Heckscher-Ohlin Model

Heckscher-Ohlin Model

BackgroundConceived by two Swedish economists, Eli Heckscher and Bertil OhlinIt builds on David Ricardo's theory of comparative advantage by predicting patterns of commerce and production based on the factor endowments of a trading region. It is based on the asssumption that countries have identical production technologies. This model more accurately describes the world economy after WWII.Eli Heckscher(1879-1952)Swedish economistMercantilistFactor endowement theory of international trade(1919)

Bertil Ohlin(1899-1979)Heckschers studentDeveloped and elaborated the factor endowment theoryProfessor at StockholmPolitical figureServed in Riksdag(swedeish parliament)Head of liberal party for almost of a centuryMinister of trade during WW2 Nobel Prize winner for international trade theory

Assumptions There are two countries involved.Two factors (labour and capital).Each country produce two commodities or goods (labor intensive and capital intensive).There is perfect competition in both commodity and factor markets.All production functions are homogeneous of the first degree i.e. production function is subject to constant returns to scale.Factors are freely mobile within a country but immobile between countries.Identical TechnologiesTrade is free i.e. there are no trade restrictions in the form of tariffs or non-tariff barriers.There are no transportation costs

Given these assumption, Ohlin's thesis contends that a country export goods which use relatively a greater proportion of its abundant and cheap factor. While same country import goods whose production requires the intensive use of the nation's relatively scarce and expensive factor.

Understanding The Concept of Factor AbundanceIn the two countries, two commodities & two factor model, implies that the capital rich country will export capital intensive commodity and the labour rich country will export labour intensive commodity. But the concept of country being rich in one factor or other is not very clear. Economists quite often define factor abundance in terms of factor prices. Ohlin himself has followed this approach. Alternatively factor abundance can be defined in physical terms. In this case, physical amounts of capital & Labour are to be compared.The Heckscher Ohlin theoremThe Heckscher Ohlin theorem states that countries which are rich in labour will export labour intensive goods and countries which are rich in capital will export capital intensive goods.ExampleImagine two countries that each produces both jeans and cell phones. Although both countries use the same production technologies, one has a lot of capital but a limited number of workers, while the other country has little capital but lots of workers.The country that has a lot of capital but few workers can produce many cell phones but few pairs of jeans because cell phones are capital intensive and jeans are labor intensive. The country with many workers but little capital, on the other hand, can produce many pairs of jeans but few cell phones.According to the Heckscher-Ohlin theory, trade makes it possible for each country to specialize. Each country exportsthe product the country is most suited to produce in exchange for products it is less suited to produce. The country that has a lot of capital specializes in the production of cell phones, whereas the country that has more labor specializes in the production of jeans.

2008 Worth Publishers International Economics Feenstra/TaylorHeckscher-Ohlin ModelNo Trade Equilibrium

No-Trade Equilibria in Home and Foreign11Figure 4.2 No-Trade Equilibria in Home and Foreign The Home production possibilities frontier (PPF) is shown in panel (a), and the Foreign PPF is shown in panel (b). Because Home is capital abundant and computers are capital intensive, the Home PPF is skewed toward computers. Home preferences are summarized by the indifference curve, U, and the Home no-trade (or autarky) equilibrium is at point A, with a low relative price of computers, as indicated by the flat slope of (PC /PS)A. Foreign is labor abundant and shoes are labor intensive, so the Foreign PPF is skewed toward shoes. Foreign preferences are summarized by the indifference curve, U*, and the Foreign no-trade equilibrium is at point A*, with a higher relative price of computers, as indicated by the steeper slope of (P*C /P*S)A*. 2008 Worth Publishers International Economics Feenstra/TaylorHeckscher-Ohlin Model

12Figure 4.3 (a): International Free-Trade Equilibrium at Home At the free-trade world relative price of computers, (PC/PS)W, Home produces at point B in panel (a) and consumes at point C, exporting computers and importing shoes. (Point A is the no-trade equilibrium.) The trade triangle has a base equal to the Home exports of computers (the difference between the amount produced and the amount consumed with trade, QC2 QC3). The height of this triangle is the Home imports of shoes (the difference between the amount consumed of shoes and the amount produced with trade, QS3 QS2). 2008 Worth Publishers International Economics Feenstra/TaylorHeckscher-Ohlin ModelNo Trade Equilibrium PriceThe no-trade prices reflect the differing amounts of resources found in the two countries.Foreign has abundant labor.Shoe production is labor intensive.The no-trade relative price of shoes is lower in Foreign.People in Foreign are willing to give up more shoes for one computer since they have a lot of shoes.The same logic applies to Home.Home has abundant capital.Computer production is capital intensive.The no-trade relative price of Computers is lower in Home.NO TRADEIndifference curve I is common to both nations because of the assumption of equal tastes. Indifference curve I is tangent to the production frontier of nation 1 at point A and tangent to the production frontier of nation 2 at AThis defines the no-trade equilibrium-relative commodity price of PA in nation 1 and PA in nation 2 (see left panel). Since PA