Factor endowments and the heckscher ohlin theory (chapter 5)

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JAGANNATH UNIVERSITY

PRESENTED BY:

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ROLL NAME

1. B-120203032 RAJIB HUSSAIN

2. B-120203034 ASIBUL ISLAM MILU

3. B-120203043 TAJRIMA SULTANA SRISTI

4. B-120203045 MOHAMMAD WASHIM

5. B-120203047 RASEL AHAMED

6. B-120203055 SUJAN BHUIYAN

7. B-120203071 GAZI RAFSAN SHAHAB

8. B-120203137 AFRIN KHAN

9. B-110203091 EHSUN HOQUE

CHAPTER 5

FACTOR ENDOWMENTS AND THE HECKSCHER-

OHLIN THEORY

RASEL AHAMED

ID: B-120203047

In this chapter:

Introduction

Assumptions of the Theory

Factor Intensity, Factor Abundance, and the Shape of the

Production Frontier

Factor Endowments and the Heckscher-Ohlin Theory

Factor-Price Equalization and Income Distribution

Empirical Tests of the Heckscher-Ohlin Model

Introduction

In this Chapter, we extend our trade model in order to identify one of the

most important determinants of the difference in the pretrade-relative

commodity prices and the comparative advantage among nations. This also

allows us to examine the effect that international trade has on the relative

price and income of the various factors of production. Our trade model so

extended is referred to as the Heckscher–Ohlin model.

5.2 Assumptions of the TheoryA. The Assumptions

1) There are two nations (1&2), two commodities (X&Y), two factors of

production (labor & capital).

Used to illustrate the theory in a two-dimensional figure.

2) Both nations use the same technology in production.

Means both nations have access to and use the same general production

techniques.

3) Commodity X is labor intensive and Y is capital intensive in both nations.

Means the labor-capital ratio (L/K) is higher for X than Y in both nations at the

same relative factor prices.

4) Both commodities are produced under constant returns to scale in

both nations.

Means that increasing the amount of L and K will increase output in the

same proportion

5) There is incomplete specialization in production in both nations.

Means that even with free trade both nations continue to produce both

commodities. This implies neither nation is very small.

6) Tastes are equal in both nations.

Means demand preferences are identical in both nations. When relative

prices are equal in the two nations, both consume X&Y in the same

proportion.

7) There is perfect competition in both commodities and factor

markets in both nations.

Means that producers, consumers, and traders of X&Y in both nations are

each too small to affect prices of commodities. Also, in the L-R

commodity prices equal their costs, leaving no economic profit.

8) There is perfect factor mobility within each nation but no

international factor mobility.

Means K&L are free to move from areas and industries of lower earnings

to those of higher earnings until earnings are the same in all areas, uses

and industries of the nation. International differences in earnings persist

due to zero international factor mobility in the absence of international

trade.

9) There are no transportation costs, tariffs, or other obstructions to the free

flow of international trade.

Means specialization in production proceeds until relative (and absolute)

commodity prices are the same in both nations with trade. If transportation costs

and tariffs were allowed, specialization would proceed only until prices differed

by no more than the costs and tariffs on each until of the commodity traded.

10) All resources are fully employed in both nations.

Means there are no unemployed resources in either nation.

11) International trade between the two nations is balanced.

Means that the total value of each nation’s exports equals the total value of the

nation’s imports.

Comment

On the basis of these assumes, the Heckscher-Ohlin theorem predicted that

the capital surplus country specializes in the production and exports of

capital intensive goods, and the labor surplus country specialize in the

production and exports of labor intensive goods.

MOHAMMAD WASHIM

ID: B-120203045

5.3 Factor Intensity, Factor Abundance, and

the Shape of the Production Frontier (PF)

A. Factor Intensity

In a world of 2 commodities and 2 factors, Y is capital intensive if its (K/L)

is greater than (K/L) of X.

If production of Y requires 2K and 2L, then K/L=1.

If production of X requires 1K and 4L, then K/L=1/4.

We say that Y is K intensive and X is L intensive.

Measuring K and L intensity depends on K/L rather than the absolute

amount of K and L.

In fig. 5-1, Nation 1 can produce 1Y using 2K-2L, and 2Y using 4K-4L.

Thus, K/L=1, this gives the slope of Y in Nation 1.

FIGURE 5-1 Factor Intensities for Commodities X and Yin Nations 1 and 2.

Nation 1 can produce 1X using 1K-4L, and 2X using 2K-8L. Thus, K/L=1/4, this

gives the slope of the ray of X in Nation 1.

In Nation 2, K/L=4 for Y and 1 for X.


Therefore, Y is the K-intensive commodity, and X is the L-intensive in Nation 2

also. This is shown by the fact that the ray from the origin for good Y is steeper than

that of X in both nations.


Even though Y is K-intensive relative to X in both nations, Nation 2 uses a higher K/L than Nation 1.

For Y, K/L=4 in Nation 2 but K/L=1 in Nation 1.

For X, K/L=1 in Nation 2 but K/L=1/4 in Nation 1.

B. Factor Abundance

Two ways to define factor abundance:

1) In terms of physical units (i.e. overall amount of K&L (TK/TL) available to eachnation).

According to this definition, Nation 2 is capital abundant if the ratio of total amountof capital to total amount of labor available in Nation 2 is greater than that inNation 1.

The ratio of TK/TL what is important , not the absolute amount of K&L available ineach nation.

Thus, Nation 2 can have less K than Nation 1 and still be the capital abundantnation if TK/TL in Nation 2 exceeds TK/TL in Nation 1.

2) In terms of relative factor prices (i.e. rental price of K (PK) and the price of L time (PL) in eachnation).

According to this definition, Nation 2 is K abundant if (PK/PL) is lower in Nation 2 than inNation 1.

Since rental price of K is taken to be the interest rate (r) and the price of labor time is wage(w), then PK/PL= r/w.

The ratio r/w what is important , not the absolute level of r that determines whether a nation isK abundant.

The first definition considers only the supply of factors, while the second definition considersboth demand and supply.

The demand of the factor is derived from demand for the final commodity that requires thefactor in its production.

C. Factor Abundance and the Shape of the Production Frontier

Since Nation 2 is K-abundant and Y is K-intensive, Nation 2 can produce relatively

more of Y than Nation 1.

Since Nation 1 is L-abundant and X is L-intensive, Nation 1 can produce relatively

more of X than Nation 2.

This gives a production frontier for Nation 1 that is relatively flatter and wider that that

of Nation 2.

FIGURE 5-2 The Shape of the Production Frontiers of Nation 1 and Nation 2.

AFRIN KHAN

ID: B-120203137

The Heckscher-Ohlin Theory

Heckscher-Ohlin (H-O) theory is based on two theorems:

1. The H-O theorem

A nation will export the commodity whose production requires the

intensive use of the nation’s relatively abundant and cheap factor and

import the commodity whose production requires the intensive use of

the nation’s relatively scarce and expensive factor.

In short, the relatively labor-rich nation exports the relatively labor-

intensive commodity and imports the relatively capital-intensive

commodity.

Explains comparative advantage rather than assuming it.

For example, if we imagine commodity X is labor intensive commodity and nation

1 produces it, on the other hand nation-2 produces commodity Y which is capital

intensive commodity. here L is available and cheap factor in nation 1 and so is K in

nation 2.

Now H-O Theorem says that, Nation-1 will export X

because X is the L-intensive

commodity and L is relatively abundant

and cheap factor in Nation 1.

Nation-1

and Nation-2 will export Y because Y is

the K-intensive commodity and K is relatively

abundant and cheap factor in Nation 2.

Nation-2

FIGURE 5-3 General Equilibrium Framework of the

Heckscher-Ohlin Theory.

1. The tastes and the distribution

in the ownership of factors of

production together determine the

demand for commodities.

2. The demand for commodities

determines the derived demand

for the factors required to produce

them.

General equilibrium

framework of the H-O Theory

FIGURE 5-3 General Equilibrium Framework of the

Heckscher-Ohlin Theory.

3. The demand for factors of

production, together with the

supply of factors, determines the

price of factors of production

under perfect competition.

4.The price of factors of

production, together with

technology, determines the price

of final commodities.

5.The difference in relative

commodity prices between nations

determines comparative advantage

and the pattern of trade.

Figure 5.3 shows clearly how all economic forces jointly determine the price of

final commodities. This is what is meant when we say that the H–O model is a

general equilibrium model.

However, out of all these forces working together, the H–O theorem isolates the

difference in the physical availability or supply of factors of production among

nations to explain the difference in relative commodity prices and trade among

nations. Specifically, Ohlin assumed equal tastes among nations.

General equilibrium framework of the H-O Theory

GAZI RAFSAN SHAHAB

ID: B-120203071

C. Illustration of the Heckscher-Ohlin Theory

Since the two nations have equal tastes, they face the same indifference map.

Indifference curve I is the highest IC that Nation 1 and Nation 2 can reach in

isolation, and points A and A/ represent their equal. points of production and

consumption in the absence of trade.

The tangency of IC I at points A and A/ defines the no-trade equal-relative

commodity prices of PA in Nation 1 and PA/ in Nation 2.

Since PA < PA/ , Nation 1 has a com-adv. in X and Nation 2 has a com-adv. in Y.

FIGURE 5-4 The Heckscher-Ohlin Model.


The right panel shows that with trade Nation 1 specializes in X and Nation 2 in

Y.

Specialization continues until Nation 1 reaches point B and Nation 2 B/, where

the transformation curves are tangent to the common relative price line PB.



Nation 1 exports X in exchange for Y and consume at point E on IC II. Nation 2 exports

Y for X and consume at point E/ (which coincides with point E).

Note that Nation 1’s exports of X equal Nation 2’s imports of X (i.e. BC=C / E /).

Similarly, Nation 2’s exports of Y equal Nation 1’s imports of Y (i.e. B / C / =C E).



At PX/PY > PB, Nation 1 want to export more of X than Nation 2 wants to import at this

high relative price, and PX/PY falls towards PB.

At PX/PY < PB, Nation 1 want to export less of X than Nation 2 wants to import at this

low relative price, and PX/PY rises towards PB.



Point E involves more of Y but less of X than point A

However, Nation 1 gains from trade because E is on higher IC II.

Similarly, at E/ which involves more X but less Y than A/, Nation 2 is better of

because E/ is on higher IC II.

TAJRIMA SULTANA SRISTI

ID: B-120203043

5.5 Factor-Price Equalization and Income Distribution

The factor price equalization theorem

International trade will bring about equalization in the relative and

absolute returns to homogenous factors across nations.

In short, wages and other factor returns will be the same after

specialization and trade has occurred.

Holds only if H-O theorem holds.

5.5 Factor-Price Equalization and Income Distribution

The factor price equalization theorem

International trade causes w to rise in Nation 1 (the low-wage nation) and fall

in Nation 2. (the high-wage nation), reducing the pre trade difference in w

between nations.

Similarly, trade causes r to fall in Nation 1 (the K-expensive nation) and rise

in Nation 2. (the K-cheap nation), reducing the pre trade difference in r

between nations.

Thus, international trade causes a redistribution of income from the

relatively expensive (scarce) factor to the relatively cheap (abundant)

factor.

FIGURE 5-5 Relative Factor–Price Equalization.

Relative and Absolute Factor-Price Equalization

Factor Price equalization Theorem

The horizontal axis measures w /r and the vertical axis PX /PY . Before trade, Nation 1 is at point A ,

with w /r = (w /r )1 and PX /PY = PA while Nation 2 is at point A` , with w /r = (w /r )2 and PX /PY

= PA`.

Since w /r is lower in Nation 1 than in Nation 2, PA is lower than PA` so that Nation 1 has a

comparative advantage in commodity X.




As Nation 1 specializes in the production of commodity X with trade and increases thedemand for labor relative to capital, w /r rises. As Nation 2 specializes in the production ofcommodity Y and increases its relative demand for capital, r /w rises (i.e., w /r falls). Thiswill continue until point B = B` , at which PB = PB` and w /r = (w /r )∗ in both nations.




PX/PY will become equal as a result of trade, and this will only occur

when w/r has also become equal in the two nations (as long as both

nations continue to produce both commodities).

Comment

The Heckscher-Ohlin Theory & Factor Price equalization Theory

According to the H–O theorem, a nation will export the commodity intensive in its

relatively abundant and cheap factor and import the commodity intensive in its

relatively scarce and expensive factor.

According to the factor–price equalization (H–O–S) theorem, international trade

will bring about equalization of relative and absolute returns to homogeneous

factors across nations.

ASIBUL ISLAM MILU

ID: B-120203034

International trade on the effect of relative factor prices within each nation

Trade increases the price of the nation’s abundant and cheap factor and reduces theprice of its scarce and expensive factor. W rises and r falls in Nation 1 while w fallsand r rises in Nation 2. International trade on the effect of income within each nation.

The real income of labor and the real income of owners of capital move in the samedirection as the movement in factor prices. Trade causes the real income of labor torise and the real income of owners of capital to fall in Nation 1 while in Nation 2 thesituation is the opposition.

5.5c Effect of International Trade on distribution of

Income

International trade on the effect of relative factor prices and the distribution of

income within each nation in the long run;

According to H-O-S theorem, international trade causes real wages and the real

income of labor to fall in a capital-abundant and labor –scarce nation (such as

developed countries). On the contrary, international trade causes real interests

and the real income of capital to fall in a labor-abundant and capital scarce

nation (such as developing countries);

Unequal distribution of income needs an appropriate distribution policy of the

government.

5.5c Effect of International Trade on distribution of

Income

EHSUN HOQUE

ID: B-110203091

5.5 Factor-Price Equalization and Income

Distribution

5.5D Specific Factors Model

Trade will:

have an ambiguous effect on a nation’s mobile factors,

benefit the immobile factors specific to a nation’s export commodities or

sectors, and

harm the immobile factors specific to a nation’s import-competing commodities

or sectors.

Specific Factors Model

In the short run when some factors may be immobile Or specific

to some industry or sector. In this case, it Assumes that trade will

have an ambiguous effect on the nation’s mobile factors : It will

benefit the immobile factors that are specific to the nation’s export

commodities or sectors, and harm the immobile factors that are

specific to the nation’s import-competing commodities or sectors.

Specific Factors Model

In the long run when all input are mobile among all Industries of a nation,

the H-O model postulates that the opening of trade will lead to an increase

in the real income or return of the inputs used intensively in the nation’s

export sectors and to a reduction in the real income or return of the inputs

used intensively in the production of the nation’s import-competing sectors.

RAJIB HUSSAIN

ID: B-120203032

5.6 Empirical Tests of the H-O Model

5.6A. The Leontief Paradox

(1) Empirical test by Wassily Leontief (1951)

Data: U.S. data for the year 1946.

Hypothesis: Since the U.S. was the most K-abundant nation in the world, it was

expected that the U.S. exported K-intensive commodities and imported L-

intensive commodities.

Test method: Calculated the amount of labor and capital in a ‘representative

bundle’ of $1 million worth of U.S. exports and import substitutes for the year

1947.

- Result: U.S. import substitutes were more K-intensive than U.S. exports.

This is called the Leontief paradox.

Empirical Tests of the Heckscher-Ohlin Model

Source of the Leontief Paradox Bias

Assumed a two factor world which required assumptions about what is

capital and what is labor.

Most heavily protected industries in U.S. were L- intensive, reduced

imports and increased domestic production of L-intensive goods.

Only physical capital included as capital, ignoring human capital

(education, job training, skills).

5.6 Empirical Tests of the H-O Model

Implications of the conflicting empirical results

The H-O model is useful in explaining international trade in

raw materials, agricultural products which is large

component of trade between developing and developing

countries.

Explanations of the Leontief Paradox

The used data was not representative;

Two-factor model (L, K) , ignoring the natural resources; (Many

production process using natural resources)

U.S. Trade policy (heavy protection of domestic labor-intensive

industries, so more labor –intensive goods export);

Only the measure of physical capital and ignoring the human capital and

“knowledge” capital;

At the same time there are many strong and convincing evidences verifying

H-O theory.

Comment

The first empirical test of the H–O model was conducted by Leontief using 1947

U.S. data. Leontief found that U.S. import substitutes were about 30 per- cent more

K intensive than U.S. exports. Since the United States is the most K -abundant

nation, this result was the opposite of what the H–O model predicted; this became

known as the Leontief paradox.

Empirical results seem to show that the traditional Heckscher–Ohlin model can

explain trade between developed and developing countries (often referred to as

North–South trade) and a highly qualified or restricted version of the H–O

can model the much larger trade among developed countries (i.e., North–North

trade).

SUJAN BHUIYAN

ID: B-120203055

5.6C Factor-Intensity Reversal

• Factor-intensity reversal refers to the situation where a commodity is L intensive

in the L-abundant nation and K intensive in the K -abundant nation.

• This may occur when the elasticity of substitution of factors in production varies

greatly for the two commodities. With factor reversal, both the H–O theorem and

the factor–price equalization theorem fail.

• Some tests show that factor reversal was fairly prevalent, some tests provide

strong confirmation of the H-O model.

5.6C Factor-Intensity Reversal

In the absence of factor intensity reversals, the Heckscher-Ohlin theorem is

valid on the basis of the price definition of factor abundance. The identity of

tastes between countries is unnecessary to assume in this case.

In the absence of factor intensity reversals, the Heckscher-Ohlin theorem is true

on the basis of the physical definition of factor abundance only if the tastes are

homogenous and similar between countries.

In the presence of factor intensity reversals, the Heckscher-Ohlin theorem is

not generally valid.

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Factor endowments and the heckscher ohlin theory (chapter 5)