International Business Chapter 5 Resources And Trade The Heckscherohlin Model Organization Model Twofactor Economy

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Chapter 5

Resources and Trade: The Heckscher-Ohlin Model

◼ 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

Case Study: Skill-Biased Technological Change and Income Inequality

Factor-Price Equalization

Empirical Evidence on the Heckscher-Ohlin Model

Trade in Goods as a Substitute for Trade in Factors: Factor Content of Trade

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

◼ 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 that will arise when countries

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

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

22 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth 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.

The chapter begins by developing a general equilibrium model of an economy with two goods that 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 that 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 that intensively use 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

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

tests of the model, beginning with a pair of case studies 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-

Chapter 5 Resources and Trade: The Heckscher-Ohlin Model 23

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 that of unskilled workers.

Another empirical observation testing the 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

◼ Answers to Textbook Problems

1. a. The first step is to compute the opportunity costs of both cloth and food. We are given the

following resource constraints:

Each unit of cloth is produced with 2 units of capital and 2 units of labor. Each unit of food is

produced with 3 units of capital and 1 unit of labor. Furthermore, the economy is endowed with

2,000 units of labor and 3,000 units of capital. Given these values, we can define the following

resource constraints:

Solve these two constraints for the quantity of food produced:

This gives us two budget constraints for food production that must both be met. The production

possibilities frontier traces out these budget constraints for food and cloth production.

24 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition

Looking at the diagram, we see that production of both food and cloth will take place when the

relative price of cloth is between the two opportunity costs of cloth. The opportunity cost of cloth

is given by the slopes of the two components of the production possibilities frontier above, 2/3

and 2. When cloth production is low, the economy will be using relatively more labor to produce

b. Note the input requirements for each good. One unit of cloth can be produced using 2 units of

capital and 2 units of labor. One unit of food is produced using 3 units of capital and 1 unit of

labor. In a competitive market, the unit cost of each good must be equal to the output price.

This gives us two equations and two unknowns (r and w). Solve for the factor prices:

w = PF − 3r

c. Looking at the two expressions in part (b), we see that an increase in the price of cloth will cause

the rental rate of capital to fall and the wage rate to laborers to rise. This makes sense, as cloth is

a labor-intensive good. An increase in its price will lead to greater production of cloth and an

increase in demand for the factor it uses intensively—labor.

d. The capital stock increases to 4,000. The labor constraint will remain unchanged, keeping the

maximum price of cloth at 2 units of food. The new capital constraint is given by:

2QC + 3QF  4,000

Thus, the minimum price of cloth is also unchanged at 2/3 units of food. The only difference now

is that the production possibilities frontier will have a larger horizontal intercept (if cloth is on the

e. The actual production point for cloth and food will depend on the relative prices of cloth and food.

If we assume that the economy is producing at a point such that all resources are being utilized

(point 3 in Figure 5-1), then we can compute the quantities of cloth and food by setting the resource

constraints equal to one another:

QF = 1,333 − 2/3QC = 2,000 − 2QC

Chapter 5 Resources and Trade: The Heckscher-Ohlin Model 25

f. Prior to the expansion of the capital stock, the economy was producing 750 units of cloth and

2. Abundance is defined in terms of a ratio not in terms of the absolute quantities. E.g. If the total amount

of capital in Australia is three times that of New Zealand, but New Zealand would still be considered a

capital abundant country since the Australia has more than three times the labour that of New Zealand.

The definition of abundance is in relative terms by comparing the ratio of labour to capital in two

countries. This means, if a country is abundant in labour in comparison to other country, then it cannot

be abundant in capital in comparison to the same country. Hence, no country is abundant in both

labour and Capital.

3. This question is similar to an issue discussed in Chapter 4. What matters is not the absolute

abundance of factors but their relative abundance. Poor countries have an abundance of labor relative to

capital when compared to more developed countries. For example, consider a large, rich country like the

United States and a small, poor country like Guatemala. Though the United States has more land, natural

resources, capital, and labor than Guatemala, what matters for trade is the relative abundance of these

4. In the Ricardian model, labor gains from trade through an increase in its purchasing power. This

result does not support labor union demands for limits on imports from less affluent countries. The

Heckscher-Ohlin model directly addresses distribution effects by considering how trade impacts the owners

of factors of production. In the context of this model, unskilled U.S. labor loses from trade because this

group represents the relatively scarce factors in this country. The results from the Heckscher-Ohlin model

26 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition

5. Specific programmers may face wage cuts due to the competition from India, but this is not inconsistent

with skilled labor wages rising. By making programming more efficient in general, this development

may have increased wages for others in the software industry or lowered the prices of the goods overall.

In the short run, though, it has clearly hurt those with sector-specific skills who will face transition costs.

There are many reasons to not block the imports of computer programming services (or outsourcing

6. The factor proportions theory states that countries export those goods whose production is intensive

in factors with which they are abundantly endowed. One would expect the United States, which

has a high capital/labor ratio relative to the rest of the world, to export capital-intensive goods if the

7. The factor price equalization is based on the fact that free trade would lead to the convergence of

wages between these countries. The theory says that when trade between two countries resumes, the

relative prices of the goods converge, this converge in turn, causes the convergence of the relative prices

of capital and labor. This says that when two countries are engaged in trading the goods, in an indirect way

these two countries are in effect trading the factors of production. In other words, a country in abundant in

labor is trading the goods produced in high ratio of labor to capital for goods produced with a low labor

capital ratio. That means the country is exporting the labor and importing the capital. This says that the

trade leads to the equalization of two countries factor prices.

But practically, in the real world, factor prices are not equalized. Mainly, the wage rates in the developing

countries are substantially lower than that of the developed countries. This may be due to the following