International Business Chapter 8 Therefore Other Things Equal Would Fall And Could Become Lower Than The

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CHAPTER 8

THE BASIS FOR TRADE:

Factor Endowments and the Heckscher-Ohlin Model

Learning Objectives:

■ Examine how relative factor endowments affect relative factor prices and generate a basis

for trade.

■ Explain how trade affects relative factor prices and income distribution.

■ Analyze how real-world phenomena can modify Heckscher-Ohlin conclusions.

I. Outline

Introduction

– Do Labor Standards Affect Comparative Advantage?

Factor Endowments and the Heckscher-Ohlin Theorem

– Factor Abundance and Heckscher-Ohlin

– Commodity Factor Intensity and Heckscher-Ohlin

– The Heckscher-Ohlin Theorem

Trade, Factor Prices, and Income Distribution

– The Factor Price Equalization Theorem

Summary

II. Special Chapter Features

In the Real World: Relative Factor Endowments in Selected Countries

In the Real World: Relative Factor Intensities in Canada

III. Purpose of Chapter

IV. Teaching Tips

A. The chapter begins with an examination of labor standards in developing countries. The

article chosen investigates the possibility that a developing country can increase its relative

abundance of unskilled labor by lowering labor standards, thereby enhancing a comparative

B. In teaching the Heckscher-Ohlin paradigm and the resulting trade theorems, it is

extremely important to lay out carefully the central assumptions of the model. In particular, it is

crucial that students understand the concept of relative factor abundance from both the physical

and price perspectives. It is useful to emphasize that the two definitions will necessarily give the

same ranking of factor abundance only when demand is identical in the two countries.

C. The second critical assumption to emphasize is the assumption of identical relative factor

intensity across commodities. Students often do not grasp the idea that according to this

assumption, commodities have the same relative factor intensity regardless of where they are

produced in the world.

D. Once the basis for trade (the Heckscher-Ohlin theorem) has been established, focus on

E. We encourage you to spend some time on the income distribution effects of trade.

Students not only find it interesting, but it is necessary to understanding much of the political

economy of trade policy. We have found it effective to begin with the Stolper-Samuelson

theorem, and then contrast it with the results of the specific-factors model. We have taken

special care in the text to consider the case of specific factors inasmuch as factors appear to be

less than perfectly mobile in the short run.

Thus we are attributing the rise in PX/PY of 10 percent entirely to a 10 percent rise in PX. This is

clearly a simplification; the actual PX/PY change of 10 percent would consist of a combination of

a rise in PX and a fall in PY. To have PX shift up by, say, 6 percent and PY shift down by 4

percent could also accomplish the main point of this diagram – that the real wage falls for

someone who consumes mostly the export good and rises for someone who consumes mostly the

import good – but in a much more cumbersome way. You can certainly make the point by

shifting the DLX curve upward and the DLY curve downward simultaneously, of course, as that is

technically more accurate.

V. Answers to End-of-Chapter Questions and Problems

1. The physical definition of factor abundance is based on the relative physical amounts of

the factors present in the country, e.g., the difference in the capital/labor ratios. The country

whose K/L ratio is the largest is defined to be the capital-abundant country. The price definition

Under the assumptions of H-O, the two definitions should give the same result.

However, if tastes differ between the two countries, then factor prices will not only reflect

different supply conditions but also different demand conditions. In this instance the price

definition and the physical definition could give conflicting conclusions about relative factor

2. According to the H-O theorem, countries should specialize in and export the product that

3. The wages in the capital-abundant country should fall and the wages in the labor-

4. Assuming that the owners of capital are worried that the distribution of income will turn

against them with trade, one concludes that the country in question must be a labor-abundant

5. Assuming that the country in question is a small country, the opening of the country to

international trade will force the monopolist to become a price taker, i.e., to sell the product in

6. If demand conditions are different between the two countries and sufficiently oriented

toward the product using relatively intensively the physically relatively-abundant factor in at

least one country, the relative autarky prices will be just opposite to what H-O would predict.

7. Assume that capital is a specific factor of production, i.e., that it cannot move from the

production of one product to the production of the other. As trade opens in the capital-abundant

country, the country will attempt to expand production of the capital-intensive good (and export

it) and contract production of the labor-intensive good (and import it). Because capital cannot

move, the change in production takes place by the movement of labor from labor-intensive

8. You should not be surprised if the composition of trade changed. Before the upheavals in

Eastern Europe and the Soviet Union, the majority of trade of most of the Eastern European

countries was with each other and with the Soviet Union through a managed and negotiated

framework. With the dissolution of the Soviet Union and the opening of trade with the West,

European countries were also exposed more fully to a new set of potential trading partners.

Hence, the relative factor endowments of the Eastern European countries vis-à-vis trading

partners and the ability to respond to those endowments changed. Given the new relative

scarcities, Heckscher-Ohlin analysis would tell us that new comparative advantages and hence a

new pattern of exports and imports would emerge. For example, Hungary is most likely capital

abundant relative to Romania but labor-abundant relative to Austria; a change in trading partners

from Romania to Austria would clearly affect Hungary’s trade pattern.

9. Given that the specific-factors PPF intercepts the good X axis at a point to the left of the

point where the “normal” PPF intercepts the axis, that the economy is characterized by

increasing costs, and that only labor is being transferred from industry Y to industry X in the

10. This statement is correct because complete factor-price equalization can take place in the

Heckscher-Ohlin framework only if product prices are the same in the two countries with trade.

11. In this case, the apparent contradiction of the Heckscher-Ohlin model could be explained

by factor-intensity reversal. In the United States, agricultural production utilizes considerable

capital and, thus, many agricultural commodities such as rice are relatively capital-intensive. In

12. The specific-factors model makes it clear why, for example, if capital is immobile owners

of capital in an import-competing product in a capital-abundant country would oppose the

initiation of international trade. This is because owners of capital in a contracting industry

unambiguously are worse off with trade. Improving the mobility of capital in this instance could

VI. Sample Exam Questions

1. Will the price definition of factor abundance produce the same conclusion as the physical

definition of factor abundance in the presence of demand reversal? Why or why not?

2. Explain how relative factor abundance can determine the nature of trade flows between

3. Will the gains from trade be larger or smaller if one of the factors is not mobile in

production? Why? Demonstrate your conclusion graphically. Is it true that if neither factor is

mobile the country will receive no gains from trade? Explain.

4. It has been argued that the effect of trade in goods and services has the same effect on

factor income distribution in a country as would be the case if factors were completely mobile

internationally. What is the reasoning behind this argument?

7. Carefully explain, for each of the following two statements, why the statement is either

TRUE or FALSE.

(a) “In a 2x2x2 Heckscher-Ohlin context, when a relatively labor-abundant

8. In the context of the “specific-factors model,” explain the income distribution impacts

within a relatively labor-abundant country of a movement from autarky to a situation of free

trade. How and why are these impacts at variance with the impacts that would occur according

to the Stolper-Samuelson theorem? Carefully explain.

9. (a) State the Heckscher-Ohlin theorem. Then, in the context of a 2x2x2 model and using

the “price definition” of relative factor abundance, illustrate and explain how this

10. (a) Assume a two-country world with two factors of production (capital and labor) and

two goods. In this context, state the Heckscher-Ohlin theorem. Then indicate the two

11. (a) In a 2x2x2 context, state the Heckscher-Ohlin theorem. Then indicate how this

theorem can be obtained, utilizing the physical definition of relative factor abundance.