978-0132146654 Chapter 5 Lecture Notes

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18 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Ninth Edition

Chapter 5

Resources and Trade: The Heckscher-Ohlin Model

.1  Chapter Organization

Model of a Two-Factor Economy

Prices and Production

Choosing the Mix of Inputs

Factor Prices and Goods Prices

Resources and Output

Effects of International Trade Between Two-Factor Economies

Relative Prices and the Pattern of Trade

Trade and the Distribution of Income

Case Study: North–South Trade and Income Inequality

Factor Price Equalization

Empirical Evidence on the Heckscher-Ohlin Model

Trade in Goods as a Substitute for Trade in Factors

Patterns of Exports Between Developed and Developing Countries

Implications of the Tests

Summary

APPENDIX TO CHAPTER 5: Factor Prices, Goods Prices, and Production Decisions

Choice of Technique

Goods Prices and Factor Prices

More on Resources and Output

.2 Chapter Overview

In Chapter 3, trade between nations was motivated by differences internationally in the relative productivity

of workers when producing a range of products. In Chapter 4, the Specific Factors model considered

additional factors of production, but only labor was mobile between sectors. In Chapter 5, this analysis

goes a step further by introducing the Heckscher-Ohlin theory.

The Heckscher-Ohlin theory considers the pattern of production and trade which will arise when countries

have different endowments of such factors of production as labor, capital, and land; where these factors are

mobile between sectors in the long run. The basic point is that countries tend to export goods that are

19 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Ninth Edition

intensive in the factors with which they are abundantly supplied. Trade has strong effects on the relative

earnings of resources, and according to theory, leads to equalization across countries of factor prices.

These theoretical results and related empirical findings are presented in this chapter.

Chapter 5 Resources and Trade: The Heckscher-Ohlin Model 20

The chapter begins by developing a general equilibrium model of an economy with two goods which are

each produced using two factors according to fixed coefficient production functions. The assumption of

fixed coefficient production functions provides an unambiguous ranking of goods in terms of factor

intensities. (A more realistic model allowing for substitution between factors of production is presented

later in the chapter with the same conclusions.) Two important results are derived using this model. The

first is known as the Rybczynski effect. Increasing the relative supply of one factor, holding relative goods

prices constant, leads to a biased expansion of production possibilities favoring the relative supply of the

good which uses that factor intensively.

The second key result is known as the Stolper-Samuelson effect. Increasing the relative price of a good,

holding factor supplies constant, increases the return to the factor used intensively in the production of

that good by more than the price increase, while lowering the return to the other factor. This result has

important income distribution implications.

It can be quite instructive to think of the effects of demographic/labor force changes on the supply of

different products. For example, how might the pattern of production during the productive years of the

“Baby Boom” generation differ from the pattern of production for post–Baby Boom generations? What

does this imply for returns to factors and relative price behavior? What effect would a more restrictive

immigration policy have on the pattern of production and trade for the United States?

The central message concerning trade patterns of the Heckscher-Ohlin theory is that countries tend to export

goods whose production is intensive in factors with which they are relatively abundantly endowed. Comparing

the United States and Mexico, for example, we observe a relative abundance of capital in the United States and

a relative abundance of labor in Mexico. Thus, goods that intensively use capital in production should be

cheaper to produce in the United States and those intensively using labor should be cheaper to produce in

Mexico. With trade, the United States should export capital-intensive goods like computers, while Mexico

should export labor-intensive goods like textiles. With integrated markets, international trade should lead

to a convergence of goods prices. Thus, the prices of capital-intensive goods in the United States and

labor-intensive goods in Mexico will rise. According to the Stolper-Samuelson effect, owners of a

country’s abundant factors (e.g., capital owners in the United States, labor in Mexico) will gain from trade,

while owners of the country’s scarce factors (labor in the United States, capital in Mexico) will lose from

trade. The extension of this result is the Factor Price Equalization theorem, which states that trade in goods

(and thus price equalization of goods) will lead to an equalization of factor prices. These income

distribution effects are more or less permanent, given that factor abundances do not quickly change within

a country. While theoretically, the gains from trade could be redistributed such that everyone is better off,

such a plan is difficult to implement in practice. The political implications of factor price equalization

should be interesting to students.

21 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Ninth Edition

After presenting the basic theory behind the Heckscher-Ohlin theory, the rest of the chapter examines empirical

tests of the model, beginning with a case study looking at income inequality in the United States Wages paid

to skilled workers in the United States have been rising at a much faster rate than those paid to unskilled

workers over the past few decades. At the same time, there has been a large increase in international trade.

Given that the United States is relatively abundant in skilled labor, the Heckscher-Ohlin theory would

predict that increased trade should lead to higher wages for skilled workers and lower wages for unskilled

workers. On the surface, this appears to be an empirical confirmation of the theory. However, other studies

argue that rising wage inequality can only partially be explained by increased trade. According to the

Heckscher-Ohlin model, the increase in skilled wages should be driven by an increase in the price of skill

intensive goods following trade. However, skill intensive goods prices have not increased by nearly the

same proportion as skilled wages. If rising wage inequality in a rich country like the United States is

driven by factor price equalization, then we should also observe a narrowing gap in developing countries

that are exporting low-skill intensive goods. However, income inequality in these nations is actually larger

than in rich countries. Finally, trade between rich and poor nations is simply not large enough to be entirely

responsible for the size of the income gap. Rather, the increasing skill premium is most likely due to

skill-biased technical innovations like computers that have increased the productivities of skilled workers

more than unskilled workers.

Another empirical observation testing validity of the Heckscher-Ohlin theory is the Leontief paradox. This

is the observation that the capital intensity of U.S. exports is actually lower than that of U.S. imports, exactly

the opposite of what the theory would predict for a capital abundant country. Further evidence of this paradox

is found in global data, with a country’s factor abundance doing a relatively poor job of predicting its trade

patterns. Finally, the theory predicts a much larger volume of trade (given observed differences in factor

endowments) than we actually see in the data. A country like China, for example, has a significant abundance

in labor. However, China’s net exports of labor-intensive goods are lower than what the theory would predict.

Similarly, U.S. net imports of labor-intensive goods are lower than what would be expected given its relative

labor scarcity. An explanation for this “missing trade” is that the assumption of identical technology across

countries is flawed. Rather, there are significant differences in productivity across countries. That said, when

the sample is restricted to trade between developed and developing countries (i.e., North–South trade), the

Heckscher-Ohlin theory fits well (e.g., the United States imports more low-skill products from Bangladesh

and more high-skill products from Germany). This observation has motivated many economists to consider

motives for trade between nations that are not exclusively based on differences across countries. These

concepts will be explored in later chapters. Despite these shortcomings, important and relevant results

concerning income distribution are obtained from the Heckscher-Ohlin theory.