the heckscher-ohlin model in theory and practice

PRINCETON STUDIES IN INTERNATIONAL FINANCE

No. 77, February 1995

THE HECKSCHER-OHLIN MODELIN THEORY AND PRACTICE

EDWARD E. LEAMER

INTERNATIONAL FINANCE SECTION

DEPARTMENT OF ECONOMICSPRINCETON UNIVERSITY

PRINCETON, NEW JERSEY

PRINCETON STUDIESIN INTERNATIONAL FINANCE

PRINCETON STUDIES IN INTERNATIONAL FINANCE arepublished by the International Finance Section of theDepartment of Economics of Princeton University. Al-though the Section sponsors the Studies, the authors arefree to develop their topics as they wish. The Sectionwelcomes the submission of manuscripts for publicationin this and its other series. Please see the Notice toContributors at the back of this Study.

The author of this Study, Edward E. Leamer, is Profes-sor of Economics and Chauncey J. Medberry Professor ofManagement at the John E. Anderson Graduate School ofManagement at the University of California, Los Angeles.He is a Fellow of the American Academy of Arts andSciences and of the Econometric Society and is a ResearchAssociate of the National Bureau of Economic Research.Professor Leamer has published several books and numer-ous articles in the fields of econometrics and internationaleconomics. His most recent book is Sturdy Econometrics:Selected Essays of Edward E. Leamer (1994). This Studywas presented as the Frank D. Graham Memorial Lectureon March 3, 1994. A complete list of Graham MemorialLecturers is given at the end of this volume.

PETER B. KENEN, DirectorInternational Finance Section


No. 77, February 1995

THE HECKSCHER-OHLIN MODELIN THEORY AND PRACTICE

EDWARD E. LEAMER

INTERNATIONAL FINANCE SECTION

DEPARTMENT OF ECONOMICSPRINCETON UNIVERSITY

PRINCETON, NEW JERSEY

INTERNATIONAL FINANCE SECTIONEDITORIAL STAFF

Peter B. Kenen, DirectorMargaret B. Riccardi, EditorLillian Spais, Editorial Aide

Lalitha H. Chandra, Subscriptions and Orders

Library of Congress Cataloging-in-Publication Data

Leamer, Edward E.The Heckscher-Ohlin Model in theory and practice / Edward E. Leamer.p. cm. — (Princeton studies in international finance, ISSN 0081-8070 ; no. 77)Includes bibliographical references.ISBN 0-88165-249-0 (pbk.) : $11.001. Heckscher-Ohlin principle. 2. Comparative advantage (International trade). I.

Title. II. Series.HF1411.L423 1995382—dc20 94-49591

CIP

Copyright © 1995 by International Finance Section, Department of Economics, PrincetonUniversity.

All rights reserved. Except for brief quotations embodied in critical articles and reviews,no part of this publication may be reproduced in any form or by any means, includingphotocopy, without written permission from the publisher.

Printed in the United States of America by Princeton University Printing Services atPrinceton, New Jersey

International Standard Serial Number: 0081-8070International Standard Book Number: 0-88165-249-0Library of Congress Catalog Card Number: 94-49591

CONTENTS

1 INTRODUCTION 1

2 THE LERNER-PEARCE DIAGRAM IN ACTION 5The Factor-Price-Equalization Theorems 5Applications of the Learner-Pearce Diagram 8

3 ALGEBRA OF THE (EVEN) HECKSCHER-OHLIN-VANEK MODEL 17Neutral Technological Differences and Home Bias 19

4 LEAMER TRIANGLES 22Effects on the United States of Physical-CapitalAccumulation in Japan 24Effects on the United States of Capital Accumulationin Germany 25

5 EVIDENCE 26Patterns of Four Countries 26Patterns over Time 33Trade Patterns and Resource Supplies 36

6 THE HECKSCHER-OHLIN MODEL AND INCOME INEQUALITY 39Three Mistaken Notions 41

REFERENCES 44

FIGURES

1 Factor-Price Determination in a Lerner-Pearce Diagram 5

2 Two-Cone Lerner-Pearce Diagram 9

3 High-Wage and Low-Wage Equilibria with a NontradedSector 9

4 Effects of a Minimum Wage with One UncoveredTradeable Sector 10

5 Capital-Scarce Equilibrium with Talented Workers on Farms 12

6 Capital-Abundant Equilibrium with Talented WorkersNot on Farms 12

7 Technological Change in the Capital-Intensive Sector 13

8 Capital Flow from a Technologically Backward Country 15

9 Foreign Direct Investment into a TechnologicallyBackward Country 15

10 Growth Paths in a Three-Factor Model 23

11 Net Exports per Worker, 1958 29




15a Net Exports of Forest Products per Worker, 1965 and 1988 34

15b Net Exports of Forest Products per Worker, 1965 and 1988(Zoomed View) 34

16a Net Exports of Labor-Intensive Manufactures per Worker,1965 and 1988 35

16b Net Exports of Labor-Intensive Manufactures per Worker,1965 and 1988 (Zoomed View) 35

17 Net Exports of Labor-Intensive Manufactures per Workerversus Capital per Worker, 1988 38

18 The Global Labor Pool, 1989 40

TABLES

1 Effects of Price Changes on U.S. Factor Earnings 24

2 Components of Ten Commodity Aggregates 27

3 Highest Correlations between Net Exports and FactorSupplies per Worker in 1988 37

1 INTRODUCTION

Able research assistance for this study was performed by Robert Murdock. Researchsupport was provided by a National Science Foundation grant.

According to the Heckscher-Ohlin factor-proportions theory of compar-ative advantage, international commerce compensates for the unevengeographic distribution of productive resources.1 This is obvious insome respects but not so obvious in others. It is not a great theoreticaltriumph to identify conditions under which countries rich in petroleumreserves export crude oil, and it would not be a great surprise to findsupportive evidence. But it is a theoretical triumph to find conditionsunder which countries that are richer in labor than land export labor-intensive agricultural products and, as a result of trade, have wages thatapproach levels prevailing in high-wage labor-scarce countries. And itwould be a great surprise to find supportive data.

The basic insight of the Heckscher-Ohlin (HO) model is that tradedcommodities are really bundles of factors (land, labor, and capital). Theexchange of commodities internationally is therefore indirect factorarbitrage, transferring the services of otherwise immobile factors ofproduction from locations where these factors are abundant to loca-tions where they are scarce. Under some circumstances, this indirectarbitrage can completely eliminate factor-price differences. Perhaps themost important implication of the HO model is that the option to sellfactor services externally (through the exchange of commodities)transforms a local market for factor services into a global market. As aresult, the derived demand for inputs becomes much more elastic, andalso more similar across countries.

A feature that goes hand in hand with an elastic labor-demandfunction is an aggregate gross domestic product (GDP) with a relativelyconstant marginal productivity of capital. This is a critical propertybecause growth induced by capital accumulation is generally limited bythe declining marginal productivity of capital.2 In an HO model of a

1 Flam and Flanders offer an account of the model’s intellectual history in theirintroduction to Heckscher and Ohlin (1991).

2 Romer (1986) sparked a boomlet of sustainable-growth models that emphasizeexternalities but that depend critically on a constant or increasing long-run marginalproductivity of capital.

1

small open economy, however, the potential decline in the marginalproductivity of capital is completely offset by a shift in the product mixtoward capital-intensive products. In a closed economy, by contrast,shifts in the product mix are necessarily more limited because every-thing has to be sold internally. Thus, growth is more easily sustained inopen economies than in closed ones.

That’s the theory. What about the facts? Is there any substantialevidence that international commerce compensates for the unevengeographical distribution of factors of production? If there is an associ-ation between trade and factor abundance, which is the direction ofcausation? What resources should be considered internationally immobileand over what period of time? Is the derived demand for labor actuallymore elastic in an open economy than a closed one? Is growth sustain-able in open economies but not in closed ones?

Facts casually and not so casually collected seem to be adding up toa convincing case against the HO model. The first was Leontief’s(1953) troubling discovery that U.S. imports in 1947 were more capitalintensive than U.S. exports. For several decades, this blow to the HOmodel was thought to have knock-out power, but Leamer (1980)showed that it missed the mark because of a misreading of the theory.Bowen, Leamer, and Sveikauskus (1987) did not intend to attack theHO model but, although doing the correct calculation, found whatseems to be a disappointingly small association across countries betweenfactors embodied in trade and factor supplies.

Another set of troubling facts was provided by Grubel and Lloyd(1975), who cataloged the surprising amount of two-way trade in evenfinely disaggregated trade data. Furthermore, trade among the industrialcountries has been growing much more rapidly than output, even asthese countries have apparently become more similar in their factorendowments.

While these troubling facts have been accumulating, a formidablegroup of trade theorists led by Brander, Dixit, Grossman, Helpman,and Krugman have been crowding the HO model out of academicdiscourse by publishing a vast array of interesting models that focus oneconomies of scale and strategic interactions.

Yet the HO model remains very much alive and well, residinghappily and prominently in every textbook on international economicswritten by authors fond of the artistic diagrams and simple, remarkabletheorems associated with the HO viewpoint. Without saying so explicitly,these textbook writers remind us that theories are neither true nor false.Theories are sometimes useful and sometimes not so useful. These

2

authors understand that data analysts may hit the HO model so hardthat it hollers “false,” and that theorists may pin the model so firmly tothe mat that it squeals “impressed,” but the authors have not heard,nor do they imagine ever to hear, the HO model scream “useless.” Infact, the HO model is extraordinarily useful pedagogically, politically,and empirically.

Pedagogically, the model offers a loud wake-up call to the limitationsof partial-equilibrium thinking. Does an increase in the supply of laborlead to a lower wage rate? “Of course,” is the partial-equilibrium answer.“Not necessarily,” is the HO answer, because trade allows the potentialeffect of an increase in the labor supply to be partly, and sometimesfully, offset by a shift of the product mix in favor of sectors that uselabor intensively. The increased supply of labor-intensive products canbe absorbed externally with little or no effect on product prices.

Politically, the HO model lends intellectual support to the warning“keep your crummy government mitts off international trade.” Thiscontrasts greatly with the appeal inspired by the modern trade theo-rists, “fight the decline of America; support an industrial policy beforeit’s too late.” According to the HO model, tariffs and quotas haveredistributive effects but reduce efficiency. When redistribution is thelegitimate goal, there is generally a better way to accomplish it. Forexample, Ross Perot’s “social tariff” to offset the wage advantage ofMexico, Latin America, and Asia might help to maintain high wages forunskilled workers in the United States, but it would be a terribly costlyway to achieve only modest changes in the U.S. income distribution.The “new” trade theorists may see the issue differently; they havebombarded us with models showing that the interest of the UnitedStates lies in “protecting” certain sectors, thereby encouraging produc-tion on a more efficient scale and also giving U.S. firms a strategicadvantage over foreign rivals. These are thought-provoking but verydangerous ideas. Every trade barrier of which I am aware was reallyerected to redistribute income, not to capture unexploited economiesof scale or strategic advantages. Rent-seeking lobbyists already haveplenty of subtle and not-so-subtle ways to coerce Congress into sup-porting their redistributive agenda. When academics supply modelsthat lend intellectual support to these schemes, lobbyists skillfully turnthe remote possibilities suggested by the models into seeming certain-ties, and they thus turn unpalatable income transfers into compellingindustrial policies.

Last but not least, the HO model is empirically useful because it helpsus to understand important aspects of the patterns of international trade.

3

The rest of this study develops the idea that the HO factor-proportionsmodel is useful in three ways: As a theory, as a description of reality,and as the key for understanding the impact of globalization on theU.S. labor market. The next chapter uses the familiar Lerner-Pearcediagram to derive some rather remarkable theoretical conclusions. Theseshould have an indelible effect on your thinking, which of course is oneof the key tests of the usefulness of a theory. Chapter 3 provides analgebraic treatment of the “even” model with equal numbers of factorsand goods and with both home bias and neutral technological differences.Chapter 4 summarizes the recent history of international commerce witha graphical three-factor, multigood model. Chapter 5 supports thesetheoretical ideas with some empirical evidence. Chapter 6 deals with thehot topic of globalization and wages.

4

can be taken as given for many comparative-static exercises, because itis determined in the international marketplace.

In this figure, machinery is relatively capital intensive and apparel isrelatively labor intensive. The solid line connecting the points labeled 1/rand 1/w is the only unit-isocost line compatible with the production ofboth of these products. Any other isocost line would either leaveunexploited profit opportunities or would force a sector out of existencebecause of negative profits.

The equation for this isocost line is $1 = wL + rK, where L and Kare the amounts of labor and capital that are employed and w and rare the corresponding rental charges for these inputs. This equationcan be solved for the two points where the isocost line crosses the axes,1/w and 1/r—hence the labeling in the figure. Perhaps without noticingit, you have now seen how to solve for the factor prices, w and r, givenproduct prices and given technologies with constant returns to scale.No reference has been made to the country except that it producesboth of the goods. To introduce a country into this figure, we needonly identify the point representing the country’s supplies of capitaland labor. If full employment is assumed, the set of capital-to-laborfactor-supply ratios compatible with the production of both goods is theinterval between the capital-to-labor ratios in apparel and machinery.This set of factor supplies is called a “cone of diversification.” Insummary, we have established the following:

The Factor-Price-Insensitivity Theorem. For a small open econ-omy, the derived demands for factors are infinitely elastic (withincones of diversification).

This may seem like an uncomfortable way of summarizing the logicthat leads from product prices and technologies to factor prices, but itis actually the most accurate way of doing so. The traditional way ofexpressing the result is:

The Factor-Price-Equalization* Theorem. Countries producingthe same mix of products with the same technologies and thesame product prices must have the same factor prices.

Regrettably, this theorem is misleadingly labeled, for by using the word“equalization,” it suggests a process rather than an outcome. To helpmake the correction, I have added the asterisk so that you can searchand replace “equalization*” with “equality.” It is the “Factor-Price-Equality Theorem,” not the “Factor-Price-Equalization Theorem.” Next

6

is a result that does refer to a process, not just the outcome:

The Factor-Price-Convergence Theorem. When two countrieseliminate their mutual trade barriers, product-price equalizationeliminates factor-price differences.

Of these three results, the Factor-Price-Insensitivity Theorem requiresthe least restrictive assumptions, and it is the theorem that most closelyfits one of our basic themes, that the option to sell commodities exter-nally turns a local labor market into a global labor market. This optionincreases the elasticity of the derived demand for labor in this 2 by 2model to infinity. The Factor-Price-Equalization* Theorem is a strongerresult and requires additional assumptions: identical technologies, nofactor-intensity reversals, and/or sufficiently similar factor-supply ratios.The Factor-Price-Convergence Theorem is different in subtle butimportant ways. First, by its lack of explicitness, it challenges us to findcombinations of assumptions regarding factor-supply differences,technological differences, and numbers of factors and goods for whicheconomic integration reduces international factor-price differences.Second, it makes explicit reference to the “signal” by which the effectsof economic integration are transmitted among countries. This signal isthe change in product prices resulting from integration—not, forexample, an elimination of technological differences or a migration offactors or even an increased volume of international trade. Both theFactor-Price-Insensitivity Theorem and the Factor-Price-Equalization*Theorem take this price signal as fixed, so they fail to provide anintellectual setting in which factor-price convergence can be studied.

Factor-price convergence induced by product-price convergence canbe studied with the aid of the Stolper-Samuelson Theorem, which linksfactor prices with product prices. It is also easy to use the Lerner-Pearce diagram to establish:

The Stolper-Samuelson Theorem. An increase in the price of thelabor-intensive product causes an increase in the real-wage rateand a reduction in the real return to capital.

To prove this result, simply shift the apparel isoquant inward towardthe origin to reflect the fact that, at a higher price for apparel, lesscapital and labor are needed to produce a dollar’s worth of output. Thisshift is accompanied by a twisting of the unit-isocost line, reflecting areduction in 1/w and an increase in 1/r.

7

Applications of the Lerner-Pearce Diagram

The Lerner-Pearce diagram has an extraordinary number of interestingapplications. Several are presented below. I shall list the result andrefer to the corresponding figure but leave readers pretty much ontheir own to connect the two.1

High wages come from product upgrading. A country will havehigh wages if it is sufficiently abundant in capital to concentrateproduction on capital-intensive products and exchange these onworld markets for labor-intensive products.

This possibility is depicted in Figure 2, which shows three products,machinery, textiles, and apparel, and two countries, the United Statesand China. The United States has high wages and produces machineryand textiles. China has low wages and produces textiles and apparel.

The United States and China are only partly integrated in Figure 2,and the remaining differences in factor costs create incentives for laborto flow from China to the United States and for capital to flow fromthe United States to China. In reality, we see both labor flows andcapital flows. The integration of East and West Germany seems to beinducing much more rapid labor flows than capital flows. In the U.S.-Japanese case, by contrast, capital has been the factor bringing about afully integrated equilibrium, not by a capital outflow from the UnitedStates, but by much higher saving and investment rates in Japan.Incidentally, factor movements in search of higher returns will changethe worldwide supplies of products and induce product-price changesthat tend to “melt” away the differences between the cones.

High wages come from high demand for nontraded goods.Communities can have high wages for unskilled workers if theyconcentrate production on capital-intensive tradeables and absorbunskilled workers, partly to produce these skill-intensive productsand partly to produce labor-intensive nontradeables.

Figure 3 illustrates this possibility with two traded goods, machineryand apparel, and one labor-intensive nontraded good, services. Twopossible equilibria are depicted, one with low wages and apparel

1 The isoquants in these figures are all right-angled and thus use capital-to-laborratios that do not vary with factor prices. This assumption of fixed input technologiesreduces the clutter in the graphs without altering the basic results. The first severalresults are standard textbook material. The latter ones are, I believe, new.

8

the uncovered tradeable as apparel that is produced in small shops,where it is difficult to enforce the minimum wage. Think of the coverednontradeable as McDonald’s and the uncovered nontradeable as house-keeping. According to this theory, wages in the uncovered garmentdistrict in Los Angeles are raised by minimum wages in the coveredaerospace industry. The higher wages must then be paid by employersin the nontradeable sector, the costs of which are passed on to con-sumers in the form of higher prices.

Talented workers receive a wage premium only in capital abun-dant countries. Workers with God-given talent will receive thesame earnings as untalented workers if they are employed for thesame tasks. If the capital-intensive sector makes use of the talent,but the labor-intensive sector does not, then capital-scarce coun-tries will have talented workers working alongside untalentedworkers in the labor-intensive sector, and both kinds of workerswill receive the same low wages. Capital accumulation expands thetalent-using capital-intensive sector, which eventually gets largeenough to employ all the talented workers, who then enjoy a wagepremium over the untalented workers. Thus, income inequalityincreases with capital accumulation.

Figures 5 and 6 illustrate two equilibria with a labor-intensive farmingsector that does not distinguish talented from untalented workers and acapital-intensive “music” sector in which the talented workers are moreproductive than the untalented workers. In Figure 5, capital is tooscarce to allow all of the talented workers to be employed producingmusic. Some of the talented workers are employed on farms, and theythus receive the same low wages as untalented workers. In Figure 6,there is enough capital to allow all the talented workers to be employedproducing music. The untalented workers also produce music, but theycommand a lower wage because they are less productive. (Note, inci-dentally, that the wages of the talented workers rise if the untalentedworkers become more productive in farming.)

If, however, the talent-using sector were labor-intensive, then capitalaccumulation would lower, not raise, income inequality. Based on thisobservation, let me throw out a half-baked idea that contrasts theindustrial revolution of the nineteenth century with the informationrevolution of the twentieth century by focusing on the capital intensityof the sector that uses the talent. The technological innovations of theindustrial revolution created mills and factories in which humans wereindistinguishable inputs. Talent remained important in the labor-intensive

11

The computer revolution seems like a good example of relatively rapidtechnological improvement in the capital-intensive sector, but it has beenaccompanied by an extraordinary decline in computer prices. Such aprice reduction in the capital-intensive sector would shift outward theunit-value isoquant for machinery and thus raise the wage rate, offsettingpartly or even completely the initial downward effect on wages.

Technological change in the nontraded-goods sector has a ratherdifferent effect, because factor prices may be determined entirely inthe traded sector. For example, suppose that the computer revolutionreduces labor requirements in the nontraded labor-intensive servicesectors. Think of automatic teller machines, answering machines,computer-aided design. Workers who are technologically displaced cancontinue to be employed in the nontraded service sector only if pricereductions in that sector are large enough to generate an offsettingincrease in demand. It is more likely, however, that these releasedworkers will be employed partly in the traded sector. The increasedsupply of workers to the traded sector forces a shift in the output mixtoward labor-intensive goods, and it will lower wages if the change inthe output mix is substantial enough.

Capital can migrate to escape an inferior technology. A superiortechnology in the United States attracts equity investments fromMexico. In Mexico, this capital outflow has a redistributive effectin favor of capital and an overall efficiency effect, the latter but notthe former depending on the amount of the capital flow.

In Figure 8, the heavy dotted line represents the final Mexican isocostline, with a rate of return to capital equal to that in the United States,but with a wage rate (w′MEX) that is low enough to offset the highercapital costs in the labor-intensive sector. The amount of capital thatexits Mexico is just enough to leave behind a capital-to-labor ratio thatis suited to the labor-intensive sector. (If the isoquant were curved, thelower Mexican wage rate would dictate a more labor-intensive techniquein Mexico than in the United States.)

Foreign direct investment transfers technology. Multinationalsthat raise capital in the United States and transfer technology toMexico cause a redistributive effect in favor of labor in Mexicoand an efficiency effect. The Mexican economy bifurcates, withthe labor-intensive sector operated by U.S. multinationals usingadvanced technology and the capital-intensive sector employingMexican capital and using backward technology.

14

In Figure 9, the heavy dotted line represents the new Mexican isocostline, with a wage rate equal to that in the United States but a return tocapital that is low enough to offset the higher labor costs in the capital-intensive sector. The U.S. multinationals transfer capital into theMexican labor-intensive sector and hire labor locally. Just enoughworkers are employed by the multinationals to leave Mexican firmswith a capital-to-labor ratio that is perfectly suited to the capital-intensive sector.

Figures 8 and 9 thus depict two very different kinds of partialintegration between an advanced country and a backward one. Capitalmay flow out of the backward country into equities in the advancedcountry, leaving behind a labor force with a lower wage rate. Alterna-tively, capital may flow from the advanced country into the backwardone, bringing with it an improved technology and increasing the demandfor labor in the backward country.

16

3 ALGEBRA OF THE (EVEN) HECKSCHER-OHLIN-VANEKMODEL

Many results of an HO model can be derived and communicated mosteffectively with graphs, but the more precise language of algebra isuseful for making assumptions clear and for introducing into the modelboth home bias and technological differences.

An elegant algebraic version of the HO general-equilibrium model isbased on the assumptions of (1) identical homothetic tastes, (2) con-stant returns to scale and identical technologies, (3) perfect compe-tition in the goods and factor markets, (4) costless international ex-change of commodities, (5) factors of production that are completelyimmobile across international borders but that can move costlesslyamong industries within a country, (6) equal numbers of goods andfactors, and (7) sufficient similarities in factor endowments to place allcountries in the same cone of diversification.

The production side of the HO model deals with the mapping ofprices (p) and resource supplies (v) into factor prices (w) and theoutput mix (q): w = f(p,v); q = g(p,v). Four theorems characterize thederivatives of these functions:

The Factor-Price-Equalization* Theorem ∂w/∂v = 0The Stolper-Samuelson Theorem ∂w/∂p ≠ 0The Rybczynski Theorem ∂q/∂v ≠ 0The Samuelson Duality Theorem ∂w/∂p = (∂q/∂v)′

With equal numbers of goods and factors, the production side of themodel can be summarized by the system of equations

q = A-1 v , (1)

w = A′-1 p , (2)

A = A(w,t) , (3)

where q is the vector of outputs, A is the input-output matrix, witheach element representing the amount of each factor used to producea unit of each good, v is the vector of factor supplies, w is the vectorof factor returns, p is the vector of commodity prices, and t is time.Equation (1), which translates factor supplies (v) into outputs (q), isthe inverted form of the factor-market equilibrium condition equating

17

the supplies of factors (v) to the demands for factors (Aq). Equation(2), which translates product prices into factor prices, is the invertedform of the zero-profit conditions equating product prices (p) toproduction costs (A′w). Equation (3) expresses the dependence ofinput intensities on factor prices (w) and on the state of technology,with A(w,t) being the cost-minimizing choice of input intensities usingthe technologies available at time t. The assumption of constant returnsto scale implies that A depends on the factor returns (w) but not onthe scale of output (q).

The consumption side of the model is neutralized by the assumptionof identical homothetic tastes. In the absence of barriers to trade, allindividuals face the same commodity prices, and they consume goodsin the same proportions:

c = s cw = s A-1 vw , (4)

where c is the consumption vector, s is the consumption share, cw isthe world consumption vector, and vw is the vector of world resourcesupplies. Thus, the vector of trade flows is

T = q − c = A-1 v − s A-1 vw = A-1(v − s vw) . (5)

The consumption share (s) will depend on the level of output andalso on the size of the trade balance (B = p′T), where p is the vector ofprices. Premultiplying (5) by the vector of prices and then rearranging,we obtain the consumption share:

s = (p′A-1 v − B)/p′A-1 vw = (GNP − B)/GNPw . (6)

This is often called the Heckscher-Ohlin-Vanek model because ofVanek’s (1968) use of the assumption of homothetic tastes. In thisHOV model, trade is a linear function of the endowments. The morebasic HO model makes no reference to linearity and merely concludesthat trade arises because of the unequal distribution of resources acrosscountries, with no trade occurring if the ratios of resources are thesame in all countries.

A very informative way of writing (5) is AT = v − s vw , that is, thefactors embodied in trade (AT) equal the excess factor supplies (v −s vw). This algebraic expression emphasizes the fact that internationaltrade is really about the exchange of factor services; commodities areonly bundles of factor services.1

1 Incidentally, this algebraic form requires only identical matrices A for differentcountries, not equal numbers of factors and commodities.

18

Neutral Technological Differences and Home Bias

Countries that opt for economic isolation tend to fall behind technolog-ically, the more so the longer the isolation persists. The former Com-munist countries are obvious examples. Indeed, it has been argued thatthe Communist command-and-control economy would have been muchlonger lived had global technology not advanced so dramatically in thesecond half of the twentieth century. The fundamental failure of theCommunist system was its inability to keep pace with or assimilate thetechnological improvements that occurred at a dizzying rate in the West.

We clearly need to amend the HO assumption of identical technologiesif we intend to pool data for the Western industrial economies with thoseof Eastern Europe, or for that matter with those of Latin America,China, India, and others that have adopted policies of separation.

It is also necessary to introduce home bias of some form. Gravitymodels have been used for several decades to demonstrate the cleareffect of distance on trade. Yet we continue to build international trademodels that make the schizophrenic assumption that countries are bothinfinitely far apart and infinitely close, the former assumption applyingto factor flows and the latter to goods flows. In fact, the costs of doingcommerce over long distances have two important effects on tradepatterns. Countries that are geographically large have lower ratios oftrade to GDP because they have much economic mass that is relativelyfar from an external border. Countries that are distant from majormarketplaces are forced to depend more on home production and tospecialize in those traded commodities that travel well over longdistances.

Both technological differences and home bias are now introduced ina way that leads to a remarkably convenient and intuitively appealingconclusion, that is, home bias and technological differences have thesame effect, reducing a country’s trade proportionately in all categories.It is easy to correct for this shrinkage effect by dividing net exports ofeach product by a measure of total trade. The HO framework can thenbe used to explain the composition of trade, although not the totalamount of trade.

Neutral technological differences among countries can be fairlyeasily added to the HO model. The production side with technologicaldifferences takes the form

qi = A-1 viδi ,

where qi is the vector of outputs, A is the input-output matrix, vi is the

19

vector of measured resource supplies, and viδi is the vector of effectiveresource supplies after adjusting for technological differences (δi).

Trefler (1993) has suggested one form of home bias that is particu-larly easy to employ. Write the consumption vector as a weighted sumof the world-production vector and the home-production vector:

ci = αi qw + γi qi ,

where qw is the vector of world output. The usual HOV assumptions ofhomothetic tastes and identical prices imply that consumption vectorsfor different countries are proportional to each other, that is γi = 0. Inthis formulation, home bias has the effect of pushing the compositionof consumption toward the home-production basket (qi). Although thisformulation is wonderfully convenient for modeling purposes, it is notobvious how to justify this form of home bias in terms of transportcosts, production functions, and utility functions. Furthermore, theformulation does not adjust for the endogeneity of the home outputmix (qi), which should be more similar to the world’s output vector forcountries that are geographically large or far from major markets.These concerns notwithstanding, we may plow ahead.

Because trade is the difference between production and consumption,

Ti = qi − ci = qi − (αi qw + γi qi) .

Defining the trade surplus as Bi = p′Ti, where p is the vector of prices,we can solve for αi from Bi = p′qi − αi p′qw − γi p′qi. Thus,

αi = [(1 − γi)GNPi − Bi]/GNPw ,

and

Ti = (1 − γi)qi − αi qw = (1 − γi)(qi − qwGNPi /GNPw) + Biqw /GNPw .

Abstracting now from trade imbalances, so that Bi = 0, this becomes

Ti = (1 − γi)(A-1 vi δi − qw p′A-1 vi δi /GNPw)

= (1 − γi)δi(A-1 vi − qw p′A-1 vi /GNPw) = (1 − γi)δi θ vi , (7)

where θ = (A-1 − qw p′A-1/GNPw). Although the world output vectorqw /GNPw and the world price level (p) depend on the set of technologymultipliers (δi), these do not vary across countries, and the matrix θaccordingly has no i subscript.

If there were no home bias (γi = 0) and no technological differences(δi = 0), then (7) would become Ti = θ vi, which lacks only the scalarmultiplier (1 − γi)δi, affecting each element of the trade vector by the

20

same proportion. Thus, home bias and neutral technological differenceshave the same effect: they alter the amount of trade but not its compo-sition.

There are two ways that one might adjust empirically for these effects.One can estimate the full system of equations, treating (1 − γi)δi as aset of uncertain parameters. Alternatively, one can eliminate theseeffects by dividing the data by total trade:

Toti = ∑j |Ti j | = (1 − γi) δi ∑j (|{θ vi} j |) .

When Ti is divided by this measure of total trade, we obtain

Ti /Toti = θ vi / ∑j(|{θ vi} j |) , (8)

a trade-intensity variable that depends only on resource ratios. Theprincipal difference between this and the usual HOV model (Equation[5]) is that this function is nonlinear.

21

4 LEAMER TRIANGLES

The algebra in the preceding chapter works very well for the evenmodel with equal numbers of factors and goods, but the graphicssuggested in Leamer (1987) may be clearer for discussing the unevenmodel. Now that Jones and Marjit (1991) have done so, it does notseem too impolite to refer to the triangular arrays used for presentingthe three-factor model as “Leamer triangles,” though Sarah Simplex1

would probably see it differently.The three-factor model illustrated in Figure 10 has one commodity

that uses human capital as an input (chemicals), three commoditiesthat use only capital and labor (apparel, textiles, and machinery), andone commodity that uses only labor (handicrafts). This set is designedto capture essential features of the postwar economic histories of theUnited States, Europe, Japan, and the emerging countries of Asia. Themodel addresses two questions: What impact did capital accumulationin Europe and Asia have on the United States and by what economicsignal are the effects communicated? The answers are that changes inthe quantity and composition of output in Europe and Asia inducedworldwide changes in relative product prices. These price changesaffected the U.S. terms of trade and also altered the compensation paidto U.S. factors of production.

In the initial equilibrium depicted in Figure 10, the United Statesfinds itself in the high-wage cone suited to the production of a highlycapital-intensive mix of products: textiles, chemicals, and machinery.Germany and Japan are in the moderate-wage cone producing apparel,textiles, and chemicals. Asia (other than Japan) is very poorly endowedin capital and finds itself in the low-wage cone producing mostlyapparel and handicrafts. The United States has a strong comparativeadvantage in machinery, but it imports chemicals from Germany,apparel and textiles from Japan, and apparel from Asia.

The arrows from the factor-supply points depict hypothetical changesin factor supplies. The United States, although enjoying an initialadvantage from the uniqueness of its endowment, finds itself crowdedover time by Japan on the one side and by Germany on the other side.In the meantime, capital accumulation takes Asia into the moderate-

1 The standard linear-programing name for this triangle is a simplex.

22

the textile point, then the factor and the commodity are “friends” (in

TABLE 1EFFECTS OF PRICE CHANGES ON U.S. FACTOR EARNINGS

Reduction inPrice of

Effect on U.S. Earnings

Raw labor Human Capital Physical Capital Skill Premium

Machinery + + − ?Chemicals 0 − 0 −Textiles − + + +

Ethier’s [1984] terminology); an increase in the price of textiles willraise the return to the factor. The opposite is true for factors withvertices on the other side of the line. As the figure is drawn, textilesare a friend of labor in the U.S. cone but an enemy of both human andphysical capital; a rise in the price of textiles increases the wage of rawlabor and lowers the returns to both physical and human capital.Things are rather different in the Japanese cone. Extend the linesegment connecting the apparel point and the chemicals point todiscover that textiles are an “enemy” of labor and human capital in theJapanese cone, and a friend of physical capital.

Conclusions regarding the effect of product-price changes on factorreturns depend substantially and subtly on the input intensities. Forexample, if the machinery point is swung to the left, to a capital-to-labor ratio less than that of chemicals, then human capital and textilesbecome friends in the capital-abundant countries. A similar phenome-non affects the relative return to human capital in the U.S. conecompared with the Japanese cone. The Japanese cone in Figure 10 isrelatively abundant in human capital, for there are paths from the U.S.cone to the Japanese cone directly toward the human-capital vertex.For that reason, the rate of return to human capital is lower in Japanthan in the United States. This is the case even though the UnitedStates has an abundance of human capital and exports products intensivein human capital (chemicals). But the opposite ordering of the rates ofreturn to human capital in Japan and the United States would occur iftextiles had a higher ratio than chemicals of physical capital to labor.

Effects on the United States of Physical-Capital Accumulation inJapan

The initial accumulation of physical capital in Japan raises Japaneseoutput of textiles and reduces Japanese output of apparel, but it does

24

not alter Japanese production of chemicals. This is a result of the(implicit) assumption that input coefficients are fixed and that humancapital is used exclusively in the production of chemicals. Thus, theoutput of chemicals is entirely determined by the supply of humancapital, and the accumulation of physical capital alone shifts the mix ofproducts from apparel to textiles, and then to machinery.

If Japan is a large enough country, the increased supply of Japanesetextiles must produce an offsetting reduction in the price. This textile-price reduction increases the gap in wages between skilled and unskilledlabor (the skill premium) in capital-abundant countries like the UnitedStates because it lowers the real return to unskilled labor and raisesthe return to human capital. Countries like Japan, in the moderate-wage cone, experience an increase in both the wage of raw labor andthe return to human capital, and their skill premium can go either upor down.

Once Japan enters the high-wage cone, its output of textiles beginsto decline and its output of machinery increases. A concomitant fall inthe price of machinery lowers the return to physical capital but increasesthe return to both human capital and the wage of raw labor. Competi-tion from Japan is thus likely to cause a deterioration in the U.S. termsof trade but to have an ambiguous effect on the skill premium.

Effects on the United States of Capital Accumulation in Germany

Initially, an accumulation of both human and physical capital in Ger-many reduces the German supply of apparel and raises the supplies ofboth chemicals and textiles. When Germany enters the high-wage cone,further capital accumulation reduces the supply of textiles and raisesthe supplies of both chemicals and machinery. A concomitant fall inthe price of chemicals reduces the skill premium by lowering thereturn to human capital without changing the wage of raw labor. A fallin the price of machinery raises the return to both human capital andraw labor and therefore has an ambiguous effect on the skill premium.

25

5 EVIDENCE

The two preceding chapters were intended to dazzle you with theoreticalinsights derived from an HO framework. If they were successful, theywill have changed fundamentally your views about unemployment,income inequality, direct investment, and global competition, withoutoffering a single piece of evidence. This chapter will complete theseduction by demonstrating the empirical accuracy of the HO model.After that, we can move on to the main point of all this: public policytoward international trade.

Demonstration of the accuracy of the HO model requires a clearlinkage of trade patterns with factor proportions. The first step is toselect some sensible level of commodity aggregation, because the rawtrade data are hopelessly detailed. Leamer (1984) invests a substantialamount of energy creating the ten commodity aggregates listed inTable 2. These aggregates were formed from observed correlationsacross countries of net export levels for more finely detailed productgroups. For example, countries that export a large amount of cork andwood also tend to export pulp and paper. These are accordingly com-bined into a forest-products aggregate.1

This aggregation scheme has two raw-materials aggregates (petro-leum and raw materials), four crops (forest products, animal products,tropical agriculture products, and cereals), and four manufactures(labor-intensive manufactures [LAB], capital-intensive manufactures[CAP], machinery [MACH], and chemicals [CHEM]). In terms of inputintensities, the four manufactured aggregates are ordered by intensitiesin physical capital, but chemicals are generally more intensive inhuman capital than is machinery. These four manufactured productsform a ladder of development that many countries have climbed,beginning with exports of apparel (LAB), moving on to textiles and ironand steel (CAP), and then to machinery (MACH) and chemicals (CHEM).

Patterns of Four Countries

Net exports per worker of these ten aggregates in 1958, 1965, 1974,and 1988 for Sweden, West Germany, the United States, and Japan are

1 The Leamer (1984) study covered 1958 and 1974. Song (1993) extended the studyand data set to 1988.

26

TABLE 2COMPONENTS OF TEN COMMODITY AGGREGATES

Aggregates SITC Aggregates SITC

Petroleum (PETRO)Petroleum and derivatives 33

Cereals, etc. (CER)CerealsFeedsMiscellaneousTobaccoOil seedsTextile fibersAnimal oil & fatFixed vegetable oils

489

1222264142

Raw materials (MAT)Crude fertilizers & mineralsMetalliferous oresCoal, cokeGas, natural & manufacturedElectrical currentNonferrous metal

272832343568

Labor-intensive (LAB)Nonmetal mineralsFurnitureTravel goods, handbagsArt apparelFootwearMisc. manufactured articlesPostal packaging, not classifiedSpecial transactions, not classifiedCoins (nongold)

668283848589919396

Forest products (FOR)Lumber, wood, & corkPulp & waste paperCork and wood manufacturesPaper

24256364

Capital-intensive (CAP)LeatherRubberTextile yarn, fabricIron & steelManufactured metal n.e.s.Sanitary fixtures & fittings

616265676981

Tropical agriculture (TROP)VegetablesSugarCoffeeBeveragesCrude rubber

567

1123

Machinery (MACH)Power generatingSpecializedMetalworkingGeneral industrialOffice & data-processingTelecommunications & soundElectricalRoad vehiclesOther transportation vehiclesProf. & scientific instrumentsPhotographic apparatusFirearms & ammunition

717273747576777879878895

Animal Products (ANL)Live animalsMeatDairy productsFishHides, skinsCrude animals & vegetablesProcessed animal & veg. oilsAnimal products n.e.s.

0123

21294394

Chemicals (CHEM)OrganicInorganicDyeing & tanningMedical, pharmaceutical productsEssences & perfumesFertilizersExplosives & pyrotechnicsArtificial resins & plasticsChemical materials n.e.s.

515253545556575859

illustrated in Figures 11 to 14.2 The scales are the same in 1958 and1965 but are larger in 1974 and larger still in 1988. These data conformrather well with the three-factor Heckscher-Ohlin history described inthe previous chapter. In 1958, the United States is not particularly tradedependent, and it exports the full range of manufactured products,especially machinery. Germany has already emerged from the war,exports the full range of manufactured products, and imports all thecrops and raw materials. Japan does not participate significantly ininternational trade but has a comparative advantage in manufactures thatare lower on the development ladder (LAB and CAP).

The Swedish trade pattern in 1958 is particularly interesting becausenet exports are completely concentrated on forest products. Net exportsof forest products amounting to $200 per worker paid for a mixed bagof imports including, especially, petroleum, tropical agricultural prod-ucts, labor-intensive manufactures, and chemicals. To understand thepattern of Swedish trade, we need to include softwood forest resourcesas one of the factors of production. These softwood resources cause a“Dutch disease” for Sweden, namely, limited industrialization becauseof natural-resource abundance. Incidentally, the United States has ananalogous comparative advantage in cereals.

There was a substantial increase in the amount of trade from 1958 to1965. Both Germany and the United States climbed the ladder ofdevelopment, becoming net importers of labor-intensive manufactures,and the United States also became a net importer of capital-intensivemanufactures. Japan was emerging as a major global competitor inmanufactures, concentrating low on the ladder of development byexporting labor-intensive manufactures but not chemicals. Swedishforest-product exports increased from $200 to $300 per worker, andthe machinery sector was just beginning to emerge.

The emergence of the machinery sector in Swedish net exports isvery pronounced by 1974, and the big increase in the price of petro-leum is evident in all four countries, which show greatly increasedpetroleum imports. Sweden paid its petroleum bill with greatly increasedexports of forest products and machinery. Indeed, one might suspectthat the higher petroleum bill was the cause of the increase in netexports of machinery—a case of Dutch disease in reverse. Otherwise,the 1974 picture is very similar to the 1965 picture, although Japan isstarting to give up on labor-intensive manufactures.

2 Be alert that these are sectoral trade numbers divided by economywide labor-supplynumbers.

28

From 1974 to 1988, both German and Japanese exports of machineryincreased enormously, apparently pushing Sweden half a step backwardinto greater reliance on net exports of capital-intensive manufactures,principally iron and steel. The United States is heavily affected by thiscompetition and ends up looking like an agrarian society but withenough human capital to support a very modestly successful chemicalssector. Unless the trade deficit apparent in this graph is offset by netexports of services, the U.S. pattern in 1988 seems unsustainable, andwe should expect a correction, probably in the machinery category.

Patterns over Time

The trade patterns of these four countries have been rather stable overtime, and the changes that have occurred seem compatible with theidea that high investment rates in Asia are crowding the United Statesand Europe out of labor-intensive manufactures and into the mostskill-intensive and capital-intensive products. To explore this idea morecompletely, Figures 15a and b and 16a and b report the full set of netexport data for forest products and for labor-intensive manufactures,comparing 1965 with 1988. A full view and a zoomed view of eachscatter are provided.

If there were no change in comparative advantage from 1965 to1988, these data would all lie on a straight line. The forest-productdata in Figures 15a and b conform relatively well to this straight-linenorm, with only a few countries in the second and fourth quadrant.The big net exporters of forest products in both years were Finland,Sweden, and Canada. Norway experienced the most substantial change,switching from being a large net exporter to a large net importer. Thestability of the trade in forest products is evident even in the zoomedview (Figure 15b), which displays only the smaller net exporters.Whatever the source of comparative advantage in forest products, it isnot changing much over time.

By contrast, comparative advantage in labor-intensive manufactures(apparel and footwear), displayed in Figures 16a and b, is very much inturmoil, with a large number of countries shifting from being netimporters to being net exporters, a feature that is particularly apparentin the zoomed view (Figure 16b). In response, France, the UnitedKingdom, Austria, and even Hong Kong have shifted in the oppositedirection. Japan and Belgium, although still having positive net exportsof this category, have substantially reduced their export dependence onlabor-intensive manufactures, falling from among the top ten netexporters to well back in the pack. Moving in the same direction, net

33

imports per worker by the United States increased by a factor oftwenty-five over this period.

The other product aggregates (not displayed) have a degree ofpermanence in comparative advantage that is closer to the forest-product pattern than the labor-intensive pattern. The news in thesescatters is thus stability, with one notable exception: crowding of themarkets for labor-intensive products. This is exactly what would bepredicted by the multicone HO model illustrated by the triangularFigure 10, which shows Asian countries taking over the markets forapparel, and Japan, Germany, and the United States shifting toward themore capital-intensive products.

Trade Patterns and Resource Supplies

Next, we need to link these trade patterns explicitly with factor supplies.Leamer (1984) argues that the patterns are adequately explained by theavailability of eleven resources: capital, professional labor (Labor 1),literate labor (Labor 2), illiterate labor (Labor 3), tropical land (Land 1),arid land (Land 2), mesothermal land (Land 3), microthermal land(Land 4), minerals, coal output, and crude oil outputs. Song (1993)updates these results, without making major changes in the conclu-sions. Here I want merely to provide enough of the data’s flavor toshow that a factor-proportions model is helpful in understandinginternational trade.

Table 3 reports the largest simple correlations between net exportsof each of the ten commodity aggregates in 1988 and factor suppliesper worker. Correlations are reported with the trade data divided, first,by the labor force and, second, by total trade, the latter allowing forhome bias and technological differences as discussed in Chapter 3. Twoof the columns refer to “vetted correlations” in which two outliers(Egypt and Panama) are excluded. This very incomplete treatment ofoutliers will remind the reader of the large effect that one or twocountries can have on these correlations.3

These simple correlations should be viewed as only a warm-up for thetheoretically sound multidimensional analysis done in Leamer (1984) andSong (1993). For our limited purposes, these simple correlations are

3 Omitting Egypt and Panama has little effect on the correlation with net exports perworker because the ratios of trade to work force are small for both countries. Thevetting has a larger effect on several commodity aggregates when net exports are dividedby total trade because both Egypt and Panama have very large levels of imports of theseaggregates compared with total trade.

36

enough. They show that trade patterns in many of these product

TABLE 3LARGEST CORRELATIONS BETWEEN NET EXPORTS AND FACTOR SUPPLIES

PER WORKER IN 1988

Net Exports per Worker Net Exports/Total Trade

Aggregate Resource CorrelationVetted

Correlationa Resource CorrelationVetted

Correlationa

Petro Oil 0.65 0.65 Oil 0.35 0.37Mat Oil 0.54 0.54 Minerals 0.59 0.59For Land 4 0.45 0.45 Land 4 0.34 0.37Trop Capital −0.52 −0.52 Capital −0.47 −0.52Anl Land 3 0.27 0.27 Land 3 0.29 0.31Cer Land 3 0.51 0.51 Land 3 0.37 0.41Lab Capital −0.42 −0.45 Land 4|

Capitalb−0.29 −0.44

Cap Capital −0.15 −0.15 Capital 0.28 0.24Mach Land 3 −0.22 −0.24 Capital 0.22 0.42Chem Labor 1 0.14 0.14 Capital 0.47 0.60

a Egypt and Panama are outliers and are excluded.b Vetting replaces Land 4 with Capital as the most important resource for labor-

intensive manufactures.

aggregates are sensibly and closely linked with factor supplies, that netexports per worker of manufactures are difficult to explain with mea-sures of factor supplies, but that net exports of machinery and chemi-cals divided by total trade are much better explained with factorsupplies, particularly after vetting. This finding suggests that home biasand/or technological differences may be confined to the most capital-intensive manufactures.

These correlations will be accurate summaries of the data if theassociations are linear and homoscedastic, which we can check bylooking at scatter diagrams. Figure 17, which compares net exports perworker of labor-intensive manufactures with capital per worker, is oneof the more interesting scatters. Nonlinearities here seem stronglypresent, with net exports per worker of labor-intensive manufacturesnot taking off until the capital-to-worker ratio reaches about $5,000,and then peaking at around $15,000 per worker. A piece-wise linearcurve has been inserted into this scatter, and it is exactly the kind ofdevelopment path that a two-factor multicone model would predict.The effect of natural resources on trade in manufactures can also beseen in this diagram, for some of the biggest importers are countries

37

6 THE HECKSCHER-OHLIN MODEL AND INCOMEINEQUALITY

The HO model seems like a pleasant and rather innocuous houseguest, but it comes with two inseparable and somewhat troublesometraveling companions, the Stolper-Samuelson Theorem and the Factor-Price-Insensitivity Theorem. These two propositions link changes inincome inequality to global commodity shocks and to migration, andthey lead to dramatic conclusions about the possible consequences ofthe economic liberalizations that are sweeping the globe. These liberal-izations have added to the global marketplace countries that have vastsupplies of labor but very little capital. If the HO model is correct andinternational trade compensates for the unequal geographic distributionof factors, these liberalizations should be accompanied by a great burstin trade. If the Stolper-Samuelson Theorem is correct and if theseliberalizations reduce relative prices of labor-intensive products inworld markets, there may be large reductions in the earnings of thoselow-skilled American workers who are economically indistinguishablefrom Chinese or Mexican workers.

This is a very alarming possibility. Look at Figure 18, which shows theglobal labor pool in 1989. Each country is represented by a line segmentwith a width equal to its population and a height equal to its industrialwage. If the height were average labor earnings and the width were thelabor force, then the area under a line segment would equal total laborearnings, which would be proportional to GDP if labor shares did notdiffer much across countries. Although these are only very rough approx-imations, the area under each line segment nonetheless gives a fairlyaccurate indication of the country’s relative economic size.

In this figure, countries are sorted by wage levels. At the left are thehigh-wage countries. At the right are the populous but very low-wagecountries. This creates a very unusual “pool” with the liquid piled uphigh at one end and hardly present at the other. What is holding upthe high end? The HO model offers three possible answers: tradebarriers, human-capital differences, and product-mix differences.Another possibility, which is straightforwardly introduced into an HOmodel, is the existence of technological differences.

According to the one-cone HO model, labor-abundant countries thatopt for isolationist policies have low wages because they shut off the

39

Although the one-cone HO model does not imply that average wagesin the United States must fall to the Chinese level, it does imply thatU.S. workers who are economically indistinguishable from Chineseworkers will receive the same compensation in an integrated equilibrium.This portends an alarming increase in income inequality in the UnitedStates as a consequence of the recent liberalizations. This drearyimplication of the one-cone HO model, however, is not replicated by themulticone model. A multicone HO model allows the capital-abundanthigh-wage countries to protect even their lowest-skilled workers fromthe pressure for wage equalization if there is enough capital to supporta capital-intensive mix of outputs, a possibility that was discussed abovein Chapter 2.

Yet another more hopeful interpretation of the vast wage differencesin Figure 18 is that they are due to technological differences. Economicliberalization can raise wages in the low-wage countries through techno-logical transfers without having any impact on wages in the high-wage,technologically advanced countries.

This linkage of globalization with wage levels is not an idle academicexercise. The recent large increase in income inequality in the UnitedStates has precipitated an extensive search for the cause. The three bigcontenders are an increased supply of unskilled workers (educationalfailures and immigration), technological changes that are replacinghumans with robots (computers), and globalization (lower prices forlabor-intensive products, less market power in autos and steel, andincreased international mobility of physical capital and technology).Measuring the effects of these forces is no easy task, and no one yetknows the exact contribution of each to the increase in income inequal-ity. Clearly the task of estimating the effect of globalization on wagesrequires a theoretical framework, and the HO model is sure to receiverenewed interest as a possible theoretical foundation for the study ofthis issue.

Three Mistaken Notions

It is not surprising to find labor economists doing data analyses withoutreference to the HO model, but substantial conceptual misunderstandingsalso appear in published discussions by prominent trade economists.2

Three mistaken notions are:

2 Estimates of the impact of “globalization” on U.S. wages are discussed in Freemanand Katz (1991), Lawrence and Slaughter (1993), Leamer (1993), Krugman and Law-rence (1994), and Wood (1994a, 1994b).

41

(1) The HO model depends on the substitutability of inputs withinsectors.

Correction: The Factor-Price-Insensitivity Theorem, the Stolper-Samuelson Theorem, and the Heckscher-Ohlin Theorem do not dependat all on substitution between inputs within sectors. These theoremsapply even if input ratios are technologically fixed. The Factor-Price-Insensitivity Theorem and the Heckscher-Ohlin Theorem are drivenfundamentally by changes in the mix of products. The Stolper-SamuelsonTheorem derives from zero-profit conditions that, when differentiated,leave input ratios unchanged.

(2) Globalization should be studied in the context of the Factor-Price-Equalization* Theorem.

Correction: The traditional Factor-Price-Equalization* Theorem is thewrong choice for studying the impact of increased foreign competitionon the U.S. economy. Chapter 2 pointed out that the theorem isnamed in a highly misleading way, for the word “equalization” suggestsa process by which wages are equalized by international commerce.Although the theorem identifies conditions under which two countriesmust have the same factor prices, it says nothing directly about theeffect of increased external competition. Quite the contrary, it is basedexplicitly on the small-country assumption that external product pricescan be taken as fixed even as the internal supply of product is varying.The Stolper-Samuelson Theorem, not the Factor-Price-Equalization*Theorem, is the correct choice for studying the effect of increasedexternal competition on wages.

(3) External shocks are transmitted to internal labor markets bychanges in the quantities of imports or exports.

Correction: According to the traditional one-cone HO model, shocksare transmitted to internal labor markets only by price changes, not byquantity changes. The Stolper-Samuelson Theorem indicates how wageschange as international prices change. The Factor-Price-InsensitivityTheorem indicates that quantity changes do not matter, basicallybecause the derived demand for labor is infinitely elastic.3

3 Motivated informally by the central idea of the HO model that commodities are justbundles of factors, labor economists have calculated the factor content of U.S. trade andfind that the net exports of labor services form a fairly small proportion of the U.S. laborforce, only −0.25 percent (Bowen, Leamer, and Sveikauskus, 1987). Labor economistsdraw the conclusion that globalization cannot have had an important effect on income

42

In conclusion, then, the HO model continues to provide surprisinginsights. Not only is it useful as a theory. It accurately explains manyprominent features of the patterns of international trade, and it is anessential ingredient in any study of the impact of globalization on theU.S. work force.

inequality. But this conclusion is a non sequitur if the HO model is used as a guide. Thefactor content of trade is determined by one set of equations (factor-market equilibriumconditions); factor prices are determined by another set of equations (zero-profitconditions). Indeed, the very essence of the Factor-Price-Insensitivity Theorem is thatvast changes in the factors embodied in trade leave completely unchanged the compen-sation that these factors command. Factors embodied in trade can change because ofinternal factor-supply changes or because of changes in the demand for foreign products(including a trade deficit). Provided these changes do not alter the prices of the goodsthat are produced by the economy in question, there will be no change in factor prices.

43

REFERENCES

Bowen, Harry P., Edward E. Leamer, and Leo Sveikauskus, “A Multi-CountryMulti-Factor Test of the Factor Abundance Theory,” American EconomicReview, 77 (December 1987), pp. 791-809.

Carruth, Alan A., and Andrew J. Oswald, “The Determination of Union andNon-Union Wage Rates,” European Economic Review, 16 (June 1982), pp.285-302.

Ethier, Wilfred J., “Higher Dimensional Issues in Trade Theory,” in RonaldW. Jones and Peter B. Kenen, eds., Handbook of International Economics,Vol. 1, Amsterdam and New York, North-Holland, Elsevier 1984, pp. 131-184.

Freeman, Richard B., and Lawrence Katz, “Industrial Wage and EmploymentDetermination in an Open Economy,” in John M. Abowd and Richard B.Freeman, eds., Immigration, Trade, and the Labor Market, Chicago,University of Chicago Press, 1991, pp. 235-260.

Grubel, Herbert G., and Peter J. Lloyd, Intra-Industry Trade: The Theory andMeasurement of International Trade in Differentiated Products, New York,Macmillan, 1975.

Heckscher, Eli F., and Bertil Ohlin, Heckscher-Ohlin Trade Theory, translat-ed, edited, and introduced by Harry Flam and M. June Flanders, Cam-bridge, Mass., MIT Press, 1991.

Jones, Ronald W., and Sugata Marjit, “The Stolper-Samuelson Theorem, theLeamer Triangle, and the Produced Mobile Factor Structure,” in AkiraTakayama, Michihiro Ohyama, and Hiroshi Ohta, eds., Trade, Policy, andInternational Adjustments, New York and San Diego, Academic Press, 1991,pp. 95-107.

Krueger, Alan B., “How Computers Have Changed the Wage Structure:Evidence from Microdata, 1984-1989,” Quarterly Journal of Economics, 108(February 1993), pp. 33-60.

Krueger, Anne O., “Factor Endowments and Per Capita Income Differencesamong Countries,” Economic Journal, 78 (September 1968), pp. 641-659.

Krugman, Paul, and Robert Z. Lawrence, “Trade, Jobs and Wages,” ScientificAmerican, 270 (April 1994), pp. 44-49.

Lawrence, Robert Z., and Matthew J. Slaughter, “Trade and US Wages: GreatSucking Sound or Small Hiccup?” Brookings Papers on Economic Activity,No. 2 (1993), pp. 161-226.

Leamer, Edward E., “The Leontief Paradox, Reconsidered,” Journal of Politi-cal Economy, 88 (June 1980), pp. 495-503.

———, Sources of International Comparative Advantage: Theory and Evidence,Cambridge, Mass., MIT Press, 1984.

44

———, “Paths of Development in the Three-Factor N-Good General Equili-brium Model,” Journal of Political Economy, 95 (October 1987), pp. 961-999.

———, “Wage Effects of a U.S.-Mexican Free Trade Agreement,” in Peter M.Garber, ed., The Mexico-U.S. Free Trade Agreement, Cambridge, Mass.,MIT Press, 1993, pp. 57-125.

———, Sturdy Econometrics: Selected Essays of Edward E. Leamer, Econo-mists of the Twentieth Century, Aldershot, Hants, and Brookfield, Vt.,Edward Elgar, 1994.

Leontief, Wassily W., “Domestic Production and Foreign Trade: The Ameri-can Capital Position Re-examined,” Proceedings of the American Philo-sophical Society, 97 (September 1953), pp. 332-349.

Romer, Paul, “Increasing Returns and Long-Run Growth,” Journal of PoliticalEconomy, 94 (October 1986), pp. 1002-1037.

Song, Ligang, “Sources of International Comparative Advantage: FurtherEvidence,” Ph.D. diss., Australian National University, 1993.

Trefler, Daniel, “The Case of the Missing Trade and Other HOV Mysteries,”University of Toronto, August 1993, processed.

Vanek, Jaroslav, “The Factor Proportions Theory: The N-Factor Case,” Kyklos,21 (October 1968), pp. 749-754.

Wood, Adrian, “Give Heckscher and Ohlin a Chance!” WeltwirtschaftlichesArchiv, 130 (No. 1, 1994a), pp. 20-49.

———, North-South Trade, Employment and Inequality: Changing Fortunes ina Skill-Driven World, Oxford, Clarendon, 1994b.

45

FRANK D. GRAHAMMEMORIAL LECTURERS

1950–1951 Milton Friedman1951–1952 James E. Meade1952–1953 Sir Dennis Robertson1953–1954 Paul A. Samuelson1955–1956 Gottfried Haberler1956–1957 Ragnar Nurkse1957–1958 Albert O. Hirschman1959–1960 Robert Triffin1960–1961 Jacob Viner1961–1962 Don Patinkin1962–1963 Friedrich A. Lutz (Essay 41)1963–1964 Tibor Scitovsky (Essay 49)1964–1965 Sir John Hicks1965–1966 Robert A. Mundell1966–1967 Jagdish N. Bhagwati (Special Paper 8)1967–1968 Arnold C. Harberger1968–1969 Harry G. Johnson1969–1970 Richard N. Cooper (Essay 86)1970–1971 W. Max Corden (Essay 93)1971–1972 Richard E. Caves (Special Paper 10)1972–1973 Paul A. Volcker1973–1974 J. Marcus Fleming (Essay 107)1974–1975 Anne O. Krueger (Study 40)1975–1976 Ronald W. Jones (Special Paper 12)1976–1977 Ronald I. McKinnon (Essay 125)1977–1978 Charles P. Kindleberger (Essay 129)1978–1979 Bertil Ohlin (Essay 134)1979–1980 Bela Balassa (Essay 141)1980–1981 Marina von Neumann Whitman (Essay 143)1981–1982 Robert E. Baldwin (Essay 150)1983–1984 Stephen Marris (Essay 155)1984–1985 Rudiger Dornbusch (Essay 165)1986–1987 Jacob A. Frenkel (Study 63)1987–1988 Ronald Findlay (Essay 177)1988–1989 Michael Bruno (Essay 183)1988–1989 Elhanan Helpman (Special Paper 16)1989–1990 Michael L. Mussa (Essay 179)1990-1991 Toyoo Gyohten1991-1992 Stanley Fischer1992-1993 Paul Krugman (Essay 190)1993-1994 Edward E. Leamer (Study 77)

46

PUBLICATIONS OF THEINTERNATIONAL FINANCE SECTION

Notice to Contributors

The International Finance Section publishes papers in four series: ESSAYS IN INTER-NATIONAL FINANCE, PRINCETON STUDIES IN INTERNATIONAL FINANCE, and SPECIALPAPERS IN INTERNATIONAL ECONOMICS contain new work not published elsewhere.REPRINTS IN INTERNATIONAL FINANCE reproduce journal articles previously pub-lished by Princeton faculty members associated with the Section. The Sectionwelcomes the submission of manuscripts for publication under the followingguidelines:

ESSAYS are meant to disseminate new views about international financial mattersand should be accessible to well-informed nonspecialists as well as to professionaleconomists. Technical terms, tables, and charts should be used sparingly; mathemat-ics should be avoided.

STUDIES are devoted to new research on international finance, with preferencegiven to empirical work. They should be comparable in originality and technicalproficiency to papers published in leading economic journals. They should be ofmedium length, longer than a journal article but shorter than a book.

SPECIAL PAPERS are surveys of research on particular topics and should besuitable for use in undergraduate courses. They may be concerned with internationaltrade as well as international finance. They should also be of medium length.

Manuscripts should be submitted in triplicate, typed single sided and doublespaced throughout on 8½ by 11 white bond paper. Publication can be expedited ifmanuscripts are computer keyboarded in WordPerfect 5.1 or a compatible program.Additional instructions and a style guide are available from the Section.

How to Obtain Publications

The Section’s publications are distributed free of charge to college, university, andpublic libraries and to nongovernmental, nonprofit research institutions. Eligibleinstitutions may ask to be placed on the Section’s permanent mailing list.

Individuals and institutions not qualifying for free distribution may receive allpublications for the calendar year for a subscription fee of $40.00. Late subscriberswill receive all back issues for the year during which they subscribe. Subscribersshould notify the Section promptly of any change in address, giving the old addressas well as the new.

Publications may be ordered individually, with payment made in advance. ESSAYSand REPRINTS cost $8.00 each; STUDIES and SPECIAL PAPERS cost $11.00. Anadditional $1.25 should be sent for postage and handling within the United States,Canada, and Mexico; $1.50 should be added for surface delivery outside the region.

All payments must be made in U.S. dollars. Subscription fees and charges forsingle issues will be waived for organizations and individuals in countries whereforeign-exchange regulations prohibit dollar payments.

Please address all correspondence, submissions, and orders to:

International Finance SectionDepartment of Economics, Fisher HallPrinceton UniversityPrinceton, New Jersey 08544-1021

47

List of Recent Publications

A complete list of publications may be obtained from the International FinanceSection.

ESSAYS IN INTERNATIONAL FINANCE

160. Stanley W. Black, Learning from Adversity: Policy Responses to Two OilShocks. (December 1985)

161. Alexis Rieffel, The Role of the Paris Club in Managing Debt Problems.(December 1985)

162. Stephen E. Haynes, Michael M. Hutchison, and Raymond F. Mikesell,Japanese Financial Policies and the U.S. Trade Deficit. (April 1986)

163. Arminio Fraga, German Reparations and Brazilian Debt: A ComparativeStudy. (July 1986)

164. Jack M. Guttentag and Richard J. Herring, Disaster Myopia in InternationalBanking. (September 1986)

165. Rudiger Dornbusch, Inflation, Exchange Rates, and Stabilization. (October1986)

166. John Spraos, IMF Conditionality: Ineffectual, Inefficient, Mistargeted. (De-cember 1986)

167. Rainer Stefano Masera, An Increasing Role for the ECU: A Character inSearch of a Script. (June 1987)

168. Paul Mosley, Conditionality as Bargaining Process: Structural-AdjustmentLending, 1980-86. (October 1987)

169. Paul A. Volcker, Ralph C. Bryant, Leonhard Gleske, Gottfried Haberler,Alexandre Lamfalussy, Shijuro Ogata, Jesús Silva-Herzog, Ross M. Starr,James Tobin, and Robert Triffin, International Monetary Cooperation: Essaysin Honor of Henry C. Wallich. (December 1987)

170. Shafiqul Islam, The Dollar and the Policy-Performance-Confidence Mix. (July1988)

171. James M. Boughton, The Monetary Approach to Exchange Rates: What NowRemains? (October 1988)

172. Jack M. Guttentag and Richard M. Herring, Accounting for Losses OnSovereign Debt: Implications for New Lending. (May 1989)

173. Benjamin J. Cohen, Developing-Country Debt: A Middle Way. (May 1989)174. Jeffrey D. Sachs, New Approaches to the Latin American Debt Crisis. (July 1989)175. C. David Finch, The IMF: The Record and the Prospect. (September 1989)176. Graham Bird, Loan-Loss Provisions and Third-World Debt. (November 1989)177. Ronald Findlay, The “Triangular Trade” and the Atlantic Economy of the

Eighteenth Century: A Simple General-Equilibrium Model. (March 1990)178. Alberto Giovannini, The Transition to European Monetary Union. (November

1990)179. Michael L. Mussa, Exchange Rates in Theory and in Reality. (December 1990)180. Warren L. Coats, Jr., Reinhard W. Furstenberg, and Peter Isard, The SDR

System and the Issue of Resource Transfers. (December 1990)

48

181. George S. Tavlas, On the International Use of Currencies: The Case of theDeutsche Mark. (March 1991)

182. Tommaso Padoa-Schioppa, ed., with Michael Emerson, Kumiharu Shigehara,and Richard Portes, Europe After 1992: Three Essays. (May 1991)

183. Michael Bruno, High Inflation and the Nominal Anchors of an Open Economy.(June 1991)

184. Jacques J. Polak, The Changing Nature of IMF Conditionality. (September 1991)185. Ethan B. Kapstein, Supervising International Banks: Origins and Implications

of the Basle Accord. (December 1991)186. Alessandro Giustiniani, Francesco Papadia, and Daniela Porciani, Growth and

Catch-Up in Central and Eastern Europe: Macroeconomic Effects on WesternCountries. (April 1992)

187. Michele Fratianni, Jürgen von Hagen, and Christopher Waller, The MaastrichtWay to EMU. (June 1992)

188. Pierre-Richard Agénor, Parallel Currency Markets in Developing Countries:Theory, Evidence, and Policy Implications. (November 1992)

189. Beatriz Armendariz de Aghion and John Williamson, The G-7’s Joint-and-SeveralBlunder. (April 1993)

190. Paul Krugman, What Do We Need to Know About the International MonetarySystem? (July 1993)

191. Peter M. Garber and Michael G. Spencer, The Dissolution of the Austro-Hungarian Empire: Lessons for Currency Reform. (February 1994)

192. Raymond F. Mikesell, The Bretton Woods Debates: A Memoir. (March 1994)193. Graham Bird, Economic Assistance to Low-Income Countries: Should the Link

be Resurrected? (July 1994)194. Lorenzo Bini-Smaghi, Tommaso Padoa-Schioppa, and Francesco Papadia, The

Transition to EMU in the Maastricht Treaty. (November 1994)195. Ariel Buira, Reflections on the International Monetary System. (January 1995)


57. Stephen S. Golub, The Current-Account Balance and the Dollar: 1977-78 and1983-84. (October 1986)

58. John T. Cuddington, Capital Flight: Estimates, Issues, and Explanations. (De-cember 1986)

59. Vincent P. Crawford, International Lending, Long-Term Credit Relationships,and Dynamic Contract Theory. (March 1987)

60. Thorvaldur Gylfason, Credit Policy and Economic Activity in DevelopingCountries with IMF Stabilization Programs. (August 1987)

61. Stephen A. Schuker, American “Reparations” to Germany, 1919-33: Implicationsfor the Third-World Debt Crisis. (July 1988)

62. Steven B. Kamin, Devaluation, External Balance, and Macroeconomic Perfor-mance: A Look at the Numbers. (August 1988)

63. Jacob A. Frenkel and Assaf Razin, Spending, Taxes, and Deficits: International-Intertemporal Approach. (December 1988)

64. Jeffrey A. Frankel, Obstacles to International Macroeconomic Policy Coordina-tion. (December 1988)

49

65. Peter Hooper and Catherine L. Mann, The Emergence and Persistence of theU.S. External Imbalance, 1980-87. (October 1989)

66. Helmut Reisen, Public Debt, External Competitiveness, and Fiscal Disciplinein Developing Countries. (November 1989)

67. Victor Argy, Warwick McKibbin, and Eric Siegloff, Exchange-Rate Regimes fora Small Economy in a Multi-Country World. (December 1989)

68. Mark Gersovitz and Christina H. Paxson, The Economies of Africa and the Pricesof Their Exports. (October 1990)

69. Felipe Larraín and Andrés Velasco, Can Swaps Solve the Debt Crisis? Lessonsfrom the Chilean Experience. (November 1990)

70. Kaushik Basu, The International Debt Problem, Credit Rationing and LoanPushing: Theory and Experience. (October 1991)

71. Daniel Gros and Alfred Steinherr, Economic Reform in the Soviet Union: Pasde Deux between Disintegration and Macroeconomic Destabilization. (November1991)

72. George M. von Furstenberg and Joseph P. Daniels, Economic Summit Decla-rations, 1975-1989: Examining the Written Record of International Coopera-tion. (February 1992)

73. Ishac Diwan and Dani Rodrik, External Debt, Adjustment, and Burden Sharing:A Unified Framework. (November 1992)

74. Barry Eichengreen, Should the Maastricht Treaty Be Saved? (December 1992)75. Adam Klug, The German Buybacks, 1932-1939: A Cure for Overhang?

(November 1993)76. Tamim Bayoumi and Barry Eichengreen, One Money or Many? Analyzing the

Prospects for Monetary Unification in Various Parts of the World. (September1994)

77. Edward E. Leamer, The Heckscher-Ohlin Model in Theory and Practice.(February 1995)

SPECIAL PAPERS IN INTERNATIONAL ECONOMICS

16. Elhanan Helpman, Monopolistic Competition in Trade Theory. (June 1990)17. Richard Pomfret, International Trade Policy with Imperfect Competition. (August

1992)18. Hali J. Edison, The Effectiveness of Central-Bank Intervention: A Survey of the

Literature After 1982. (July 1993)

REPRINTS IN INTERNATIONAL FINANCE

26. Peter B. Kenen, The Use of IMF Credit; reprinted from Pulling Together: TheInternational Monetary Fund in a Multipolar World, 1989. (December 1989)

27. Peter B. Kenen, Transitional Arrangements for Trade and Payments Among theCMEA Countries; reprinted from International Monetary Fund Staff Papers 38(2), 1991. (July 1991)

28. Peter B. Kenen, Ways to Reform Exchange-Rate Arrangements; reprinted fromBretton Woods: Looking to the Future, 1994. (November 1994)

50

The work of the International Finance Section is supportedin part by the income of the Walker Foundation, establishedin memory of James Theodore Walker, Class of 1927. Theoffices of the Section, in Fisher Hall, were provided by agenerous grant from Merrill Lynch & Company.

ISBN 0-88165-249-0Recycled Paper

the heckscher-ohlin model in theory and practice

Documents