ECON 457:
International
Economics I
Department of Economics
Kwame Nkrumah University of Science and Technology
CHAPTER F I V E
5 ECON 467:
International
Economics
Twelfth Edition
Factor Endowments and the
Heckscher-Ohlin Theory
Dominick Salvatore
John Wiley & Sons, Inc.
Learning Goals:
Explain how comparative advantage is based on differences in
factor endowments across nations
Explain how trade affects relative factor prices within and across
nations
Explain why trade is likely to be only a small reason for higher
skilled-unskilled wage inequalities
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc. 3
6.1 Introduction
We have seen in the previous chapters that the difference in relative
commodity prices between two nations is evidence of their
comparative advantage and
forms the basis for mutually beneficial trade
We now go one step further and explain the reason, or cause, for the
difference in relative commodity prices and comparative advantage
between the two nation
First, we explain the basis of (i.e., what determines) comparative
advantage
Second, we will extend the trade model is to analyze the effect that
international trade has on the earnings of factors of production in the
two trading nations.
6.1 Introduction
Two important questions were left largely unanswered by Smith
and Ricardo
According to classical economists, comparative advantage was based
on the difference in the productivity of labor (the only factor of
production they explicitly considered) among nations
They provided no explanation for such a difference in productivity,
except for possible differences in climate.
6.1 Introduction
Heckscher-Ohlin theory based comparative advantage on
differences in factor endowments among nations.
It clarifies the meaning of factor intensity and factor abundance,
and explains how the latter is related to factor prices and the
shape of the production frontier in each nation
The effect of international trade on factor earnings and income
distribution in the two nation
6.2 The Heckscher-Ohlin Model
H-O assumptions
1. There are two nations (Nation 1 and Nation 2), two commodities (commodity X
and commodity Y), two factors of production (labor and capital).
2. Both nations use the same technology in production.
If factor prices were the same in both nations, producers in both nations would
use exactly the same amount of labor and capital in the production of each
commodity.
Since factor prices usually differ, producers in each nation will use more of the
relatively cheaper factor in the nation to minimize their costs of production.
3. Commodity X is labor intensive, and commodity Y is capital intensive in both
nations.
4. Both commodities are produced under constant returns to scale in both nations.
5. There is incomplete specialization in production in both nations.
6.2 The Heckscher-Ohlin Model
H-O assumptions
6. Tastes are equal in both nations.
7. There is perfect competition in both commodities and factor
markets in both nations.
8. There is perfect factor mobility within each nation but no
international factor mobility.
9. There are no transportation costs, tariffs, or other obstructions to
the free flow of international trade.
10. All resources are fully employed in both nations.
11. International trade between the two nations is balanced
5.3 Factor Intensity, Factor Abundance, and the Shape of the
Production Frontier
Factor intensity refers to the relative amounts of capital and
labor used in producing a good.
In a two-commodity, two factor world, commodity Y is capital intensive if
the capital-labor ratio (K/L) used in the production of Y is greater than K/L
used in the production of X.
It is not the absolute amount of capital and labor used in production of X and
Y, but the amount of capital per unit of labor that determines capital intensity.
Likewise, commodity X is labor-intensive if the capital-labor ratio (K/L) used
in the production of X is less than K/L used in the production of Y.
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5.3 Factor Intensity, Factor Abundance, and the Shape of the
Production Frontier
Factor intensity refers to the relative amounts of capital and labor used
in producing a good.
For example,
if two units of capital (2K) and two units of labor (2L) are required to produce
one unit of commodity Y, the capital–labor ratio is one.
That is, 2 ⁄2 in the production of Y.
If at the same time 1K and 4L are required to produce one unit of X, K/L =1 ⁄4 for
commodity X.
Since K / L = 1 for Y and K/ L = 1 ⁄4 for X, we say that
Y is K intensive and
10
X is L intensive.
FIGURE 5-1 Factor Intensities for Commodities X and Y
in Nations 1 and 2.
Nation 1 can produce 1Y with 2K and 2L. On the other hand, 1K and 4L are required to produce
With 4K and 4L, Nation 1 can produce 2Y 1X, and 2K and 8L to produce 2X, in Nation 1. Thus,
because of constant returns to scale K/L=1 ⁄4 for X in Nation 1. this is given by the slope
(assumption 4). Thus, K/L= 2 ⁄2 = 4 ⁄4 = 1 of ¼.
for Y. Since the slope is higher for Y than X, Y is K-Int.
FIGURE 5-1 Factor Intensities for Commodities X and Y
in Nations 1 and 2.
In Nation 2, K/ L (or the slope of the ray) is 4 for Y and 1 for X
Therefore, Y is the K-intensive commodity, and X is the L-intensive commodity in Nation 2 also.
This is illustrated by the fact that the ray from the origin for commodity Y is steeper (i.e., has a
greater slope) than the ray for commodity X in both nations.
5.3 Factor Intensity, Factor Abundance, and the Shape of the
Production Frontier
Factor abundance is the resource richness of nations.
In terms of physical units:
Nation 2 is capital abundant if the ratio of the total amount of
capital to the total amount of labor (TK/TL) available in Nation 2
is greater than that in Nation 1.
It is not the absolute amount of capital (K) and labor (L) available
in each nation, but the ratio of the total amount of capital to the
total amount of labor.
If one country is capital rich (more capital relative to labor) then
the other is labor rich (more labor relative to capital). 13
5.3 Factor Intensity, Factor Abundance, and the Shape of the
Production Frontier
In terms of relative factor prices:
Nation 2 is capital abundant if the ratio of the rental price of capital
to the price of labor time (PK/PL) is lower in Nation 2 than in Nation 1.
If Nation 1 is abundant in labor then, ceteris paribus, labor will be
relatively cheaper in Nation 1 than in Nation 2. Vice versa.
Rental price of capital is usually considered to be the interest rate (r),
while the price of labor time is the wage rate (w), so PK/PL = r/w.
If (w/r)N1 < (w/r)N2 then (r/w)N1 > (r/w)N2, so capital is relatively cheaper in the
Nation 2.
It is not the absolute level of r that determines whether a nation is K-
abundant, but r/w.
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Nation 2 is K-abundant, and
commodity Y is K-intensive
Nation 1 is L-abundant, and
commodity X is L-intensive
FIGURE 5-2 The Shape of the Production Frontiers of
Nation 1 and Nation 2.
The production frontier of Nation 1 is flatter and wider than the production frontier of Nation 2,
indicating that Nation 1 can produce relatively more of commodity X than Nation 2.
The reason for this is that Nation 1 is the L-abundant nation and commodity X is the L-intensive
commodity.
5.4 Factor Endowments and the Heckscher-Ohlin Theory
Heckscher-Ohlin (H-O) theory is based on two theorems (H-O and
factor price equalization):
1. The Heckscher-Ohlin 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.
For this reason, the H–O model is often referred to as the factor-
proportions or factor-endowment theory 18
5.4 Factor Endowments and the Heckscher-Ohlin Theory
In other words, the H–O theorem postulates that the difference in
relative factor abundance and prices is the cause of the pretrade
difference in relative commodity prices between two nations.
This difference in relative factor and relative commodity prices is
then translated into a difference in absolute factor and commodity
prices between the two nations
It is this difference in absolute commodity prices in the two
nations that is the immediate cause of trade.
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5.4 Factor Endowments and the Heckscher-Ohlin Theory
H-O theorem implies:
The relatively labor-rich nation exports the relatively labor-
intensive commodity and imports the relatively capital-intensive
commodity.
The relatively capital-rich nation exports the relatively capital-
intensive commodity and imports the relatively labor-intensive
commodity.
Explains comparative advantage rather than assuming it.
Differences in factor endowments explain pre-trade price
differentials and thus the pattern of trade.
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5.4 Factor Endowments and the Heckscher-Ohlin Theory
The H-O theorem is a general equilibrium model.
Tastes and the distribution of income determines the demand for
commodities.
Demand for commodities determines the derived demand for the factors that produce
them.
Demand for factors and supply of factors (resource endowment) determine the price of
factors of production.
Price of factors and technology determine supply of commodities.
Supply and demand for commodities determine output prices.
Difference in relative commodity prices determine the pattern of
trade. (Figure 5.3)
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5.4 Factor Endowments and the Heckscher-Ohlin Theory
Illustration of the H-O Model (Figure 5.4)
Because tastes are the same, indifference curves are identical, but
different PPFs implies different autarky prices (points A and A’).
With trade, prices equalize to the world price line, PB.
Both nations then are able to reach higher indifference curves.
Note that the nations do not need to start and end on the same
indifference curve; this is done for graphical simplicity.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc. 23
Why is Indifference
curve I is common to
both nations?
FIGURE 5-4 The Heckscher-Ohlin Model.
A and A’ defines the no-trade equilibrium-relative commodity price in both nations
Since PA< PA' Nation 1 has a comparative advantage in commodity X and Nation 2 in commodity Y.
With trade, Nation 1 produces at point B and by exchanging X for Y reaches point E in consumption.
Nation 2 produces at B′ and by exchanging Y for X reaches point E′ (which coincides with E).
Both nations gain from trade because they consume on higher indifference curve II
FIGURE 5-4 The Heckscher-Ohlin Model.
Factor-Price Equalization and Income Distribution
The second theorem that H-O theory is based on is:
2. 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 in both nations after specialization and trade has
occurred.
Holds only if H-O theorem holds.
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5.5 Factor-Price Equalization and Income Distribution
Why do factor prices equalize?
As Nation 1 increases the production of X (and reduces the
production of Y), the demand for labor rises relative to the
demand for capital.
As Nation 2 increases the production of Y (and reduces the
production of X), the demand for capital rises relative to the
demand for labor.
Wages (w) rise in Nation 1 (the low-wage nation) and fall in Nation 2. (the
high-wage nation).
Interest rates (r) falls in Nation 1 (the K-expensive nation) and rises in
Nation 2. (the K-cheap nation).
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5.5 Factor-Price Equalization and Income Distribution
For homogeneous factors of production, wages and the rental rate
on capital will completely equalize.
As long as relative factor prices differ, there are differences in
commodity prices, which expand trade.
Expansion of trade reduces the difference in factor prices and
thus the difference in commodity prices.
Trade expands until commodity prices equalize, which implies
that factor prices have also equalized. (Figure 5.8)
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FIGURE 5-5 Relative Factor–Price Equalization.
5.5 Factor-Price Equalization and Income Distribution
If all the assumptions of the H-O model hold,
trade brings about both relative and absolute factor price
equalization.
Trade is a substitute for the international mobility of capital and
labor.
With perfect mobility, labor moves to the high-wage country; capital
moves to the high-interest country.
Thus the supply of factors adjusts until factor prices equalize (and
commodity prices equalize.
Trade works through the demand for factors.
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5.5 Factor-Price Equalization and Income Distribution
Since trade changes the return to factors of production, it
changes the distribution of income.
Causes a redistribution of income from the relatively expensive
(scarce) factor to the relatively cheap (abundant) factor.
Thus labor gains in labor-abundant nations (China, India), and
capital gains in capital-abundant nations (the U.S., Germany,
Japan).
Effects are greater in the long run, since factors will be more
mobile.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc. 32
5.5 Factor-Price Equalization and Income Distribution:
Exceptions
Specific Factors Model
Assume that within Nation 1, labor is mobile but capital is
specific to each industry.
Opening trade increases the production of X and raises wages
(which must be equal between sectors since labor is mobile).
The effect on the real wage is unclear since the increase in relative
commodity prices must be greater than the increase in the nominal
wage, as long as the supply of labor is not perfectly inelastic.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc. 33
5.5 Factor-Price Equalization and Income Distribution:
Exceptions
Opening trade cannot cause capital to move, since it is industry-
specific.
The return on capital in the production of X rises.
The return on capital in the production of Y falls.
Thus overall, 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.
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5.5 Factor-Price Equalization and Income Distribution:
Exceptions
Has trade equalized the return to homogenous factors?
Has reduced rather than eliminated differences.
Not all H-O assumptions hold.
Other forces have had effects on factor prices as well, particularly
technological change.
Does not imply that differences in per capita incomes will be
eliminated or reduced.
Other forces, such as the participation rate, the dependency ratio, and
the ratio of skilled to unskilled labor have major effects.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc. 35
5.6 Empirical Tests of the Heckscher-Ohlin Model: Exceptions
Difficult to test empirically
The Leontief Paradox
A 1951 test of the H-O theory
Estimated K/L for import substitutes since import data was not available.
Showed that the pattern of trade did not fit the conclusions of the H-O
theorem.
Exports in the U.S. seemed to be labor intensive when they should
have been capital intensive.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc. 36
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).
Many later studies have generally supported H-O, but empirical testing
remains difficult.
Salvatore: International Economics, 12th Edition © 2016 John Wiley & Sons, Inc. 37
Empirical Tests of the Heckscher-Ohlin Model
Factor-Intensity Reversal
A commodity is the L-intensive commodity in the L-abundant
nation and the K-intensive commodity in the K-abundant nation.
Elasticity of substitution measures the ease with which one factor can be
substituted for another in the production of a given commodity.
When countries have very different elasticities of substitution, factor-
intensity reversal is more likely to occur.
If this occurs, neither H-O nor factor price equalization theorems
hold.
Rare in the real world, and usually occurs only where there is a significant
natural resource input in an industry.
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