Download INTERNATIONAL TRADE

INTERNATIONAL
TRADE
LECTURE 8:
The Basis For Trade
Factor Endowments and the Heckscher-Ohlin Model
Contents

To introduce the relationship between labor
standards and comparative advantage

To research the relevance of supply, demand,
and autarky prices

To explain the factor endowments and the
Heckscher-Ohlin Theorem

To understand the theoretical qualifications to
Heckscher-Ohlin Thorem
Introduction

The role of labor standards in fostering
international trade is really important and attract
interest widespread
 Production
of labor-intensive goods has continued to
move to developing countries with increased
globalization
 Some economists believed that different categories of
labor standards have an effect on comparative
advantage in developing countries

low labor standards  comparative advantage in unskilled
labor intensive goods  increased export
Introduction

They insist to built import barriers to ensure a more
“level playing field”
 Empirical

work
Focused on core labor standards rather than
acceptable conditions of work
Core labor: elimination of discrimination against women;
union rights; freedom from forced labor; abolition of child
labor; equal opportunities
 Acceptable conditions of work: minimum wages; safety
and health standards

Introduction
Hypothesize: lower core labor standards would
lead to a relative increase in unskilled labor and
thus increase relative exports of unskilled labor
intensive goods
 Conclusions

greater discrimination against women weakened
comparative advantage
 Weaker union rights, greater child labor, and greater use
of forced labor increased export share
 The number of ratifications of the ILO conventions
appeared to have no significant effect
 Educational attainment and the overall relative labor
endowment had relatively stronger influences on the
trade patterns than did the labor standard variables

Introduction



It is necessary to use a more formal structure to sort out the
complexities of international comparative advantage
What we discussed in last lecture is that a country will gain
from trade any time that the terms of trade differ from its
own relative prices in autarky (source of trade gain)
This lecture we focus on differences in supply conditions
and try to provide a deeper understanding of the critical
factors underlying relative cost differences and therefore
comparative advantage
Quantities of factor of production  prices of factor of production  international trade
International trade  prices of factor of production  comparative advantages
Supply, Demand, and Autarky Prices

The source of difference in pretrade price ratios
between countries lies in the interaction of
aggregate supply and demand
Supply, Demand, and Autarky Prices



It is clear that there is a basis for trade whenever
supply conditions or demand conditions vary
between countries
This assumes there is no intervention in the
markets to alter prices from these general
equilibrium results
Although taxes and subsidies can cause autarky
prices to be more or less different prior to trade,
we now only examined the role of factor
availabilities in international trade
Factor Endowments and
the Heckscher-Ohlin Theorem

Simplifying assumptions of H-O Theorem
 There
are two countries, two homogeneous goods,
and two homogeneous factors of production whose
initial levels are fixed and assumed to be relatively
different for each country (different factor
endowment)
 Technology is identical in both countries; that is,
production functions are the same in both countries
(fixed PPF)
 Production is characterized by constant returns to
scale for both commodities in both countries
 The two commodities have different relative factor
intensities, and the respective commodity factor
intensities are the same for all factor price ratios
Factor Endowments and
the Heckscher-Ohlin Theorem





Tastes and preferences are the same in both countries. Further,
for any given set of product prices, the two products are
consumed in the same relative quantities at all levels of income;
that is, there are homothetic tastes and preferences (same IC
and fixed slope)
Perfect competition exists in both countries (no invention)
Factors are perfectly mobile within each country and not mobile
between countries (fixed and same domestic factor price)
There are no transportation costs
There are no policies restricting the movement of goods between
countries or interfering with the market determination of prices
and output (no invention from the government)
Factor Endowments and
the Heckscher-Ohlin Theorem

Factor Abundance and Heckscher-Ohlin
 Factor
endowments
Different factor endowments refers to different
relative factor endowments
 Relative factor abundance may be defined in two
ways: the physical definition and the price
definition

The physical definition (quantity conception): in terms of
the physical units of two factors
(K/L)I > (K/L)II
focus on physical availability of supply (capital intensity)
 The price definition (monetary conception): in terms of
the relative scarcity prices
(r/w)I < (r/w)II
focus on factor price (capital intensity)
 What is the link between above two?

Factor Endowments and
the Heckscher-Ohlin Theorem

The factor price reflects not only the supply of
available factors but also the demand
The demand for a factor of production is a derived
demand
 Factor prices reflect not only the physical availability of
the factors in question but also the structure of final
demand and the production technology employed
 Assumption of H-O theorem: technology and tastes and
preferences are the same in both countries
 Conclusion: the country with the relatively larger K/L ratio
also will have the relatively smaller r/w ratio with
technology and demand influences neutralized between
the two countries, no matter which definition we take

Factor Endowments and
the Heckscher-Ohlin Theorem

Commodity Factor Intensity and HeckscherOhlin (with physical definition)
 A factor-x-intensive
commodity: the ratio of factor x to
a second factor y is larger when compared with a
similar ratio of factor usage of a second commodity
 H-O assumes not only that the two commodities have
different factor intensities at common factor prices but
also that the difference holds for all possible factor
price ratios in both countries
 This is a strong assumption and it is critical to the H-O
analysis and it does not preclude substituting effect
 Example: two country, two factors, two commodities
Factor Endowments and
the Heckscher-Ohlin Theorem
Factor Endowments and
the Heckscher-Ohlin Theorem

The Heckscher-Ohlin Theorem
 The
PPF will differ between two countries
solely as a result of their differing factor
endowments
With identical technology, constant returns to scale,
and a given factor intensity relationship between
final products, the country with abundant capital
will be able to produce relatively more of the
capital intensive good, vice versa
 The shape and position of the PPF is determined
by the factor intensities of the two goods and the
amount of each factor available

Factor Endowments and
the Heckscher-Ohlin Theorem
Considering K/L （r/w）
Country I’s PPF is oriented more toward steel, and
Country II’s PPF is oriented more toward cloth
Capital intensive
Labor intensive
Factor Endowments and
the Heckscher-Ohlin Theorem


Combined the two PPF above and the same set of tastes and
preferences, two different sets of relative prices will emerge in
autarky, thus trade basis
The trade implications
Ps1<Ps2
Pc1>Pc2
Country I is capital abundant,
and country II is labor abundant
Country I export steel, and
country II export cloth
Factor Endowments and
the Heckscher-Ohlin Theorem

A similar discussion in terms of the price
definition
 (r/w)I
< (r/w)II With identical technology and
constant returns to scale, country I will be
able to produce steel relatively more cheaply
than country II, and country II can produce
cloth relatively more cheaply than country I
 Relationship between relative factor prices
and relative product prices can be developed
through isoquant-isocost analysis

Factor Endowments and
the Heckscher-Ohlin Theorem
(r/w)I < (r/w)II that is to say (w/r)I > (w/r)II
 For country I, MN, (w/r)I, X and Y, S1 and C1
 For country II M’N’, (w/r)II, Q and T, S1 and C2, C2>C1
Cloth in country II is cheaper, and
steel in country I is cheaper
Conclusion: a higher w/r leads to a
higher relative price of cloth
Factor Endowments and
the Heckscher-Ohlin Theorem
 Different
relative factor prices will generate
different relative commodity prices in autarky,
each country expanded production of and
exported the good that made the more
intensive use of its relatively abundant factor
of production
Factor Endowments and
the Heckscher-Ohlin Theorem

Heckscher-Ohlin theorem
 A country
will export the commodity that uses
relatively intensively its relatively abundant
factor of production, and it will import the good
that uses relatively intensively its relatively
scarce factor of production
Factor Endowments and
the Heckscher-Ohlin Theorem

The Factor Price Equalization Theorem





After participate in the trade, prices adjust until both countries
face the same set of relative prices (before trade: (w/r)I > (w/r)II)
In H-O framework, this convergence of product prices takes
place as the price of the product using the relatively abundant
factor increases with trade and the price of the product using the
country’s relatively scarce factor falls
Note: under perfect competition, production will shift along the
PPF and resources must be shifted from one to another
The adjustment of commodity price will affect the price of factor.
Considering Country II, labor abundant country
After participate in the trade, what will happen to country II?




Pc rise, Ps fall
Resources shift -> DL rise, DK fall
PL rise, PK fall
w/r rise -> K/L rise due to substitution effect
Factor Endowments and
the Heckscher-Ohlin Theorem
Capital
Labor
Factor Endowments and
the Heckscher-Ohlin Theorem

The change of factor prices will cause the factor prices ratio, (w/r)II,
to rise and induce producers to move to a different equilibrium
point on each respective isoquants (C decrease and S increase).
the K/L will rise

Similar adjustment take place in Country I while the w/r decrease
and K/L decrease
Factor Endowments and
the Heckscher-Ohlin Theorem
 The
Factor Price Equalization Theorem
Prior to trade (w/r)I > (w/r)II
 After trade (w/r)I = (w/r)II
 In equilibrium, with both countries facing the same
relative (and absolute) product prices, with both
having the same technology, and with constant
returns to scale, relative (and absolute) costs will
be equalized. The only way this can happen is if, in
fact, factor prices are equalized.

Factor Endowments and
the Heckscher-Ohlin Theorem
 Trade
in final goods essentially substitutes for
movement of factors between countries, leading to an
increase in the price of the abundant factor and a fall
in the price of the scarce factor among participating
countries until relative factor prices are equal
Factor Endowments and
the Heckscher-Ohlin Theorem
 We
do not observe factor price equalization theorem
in practice for its assumptions are not realized or not
realized as fully as stated in the model

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Transportation cost
Tariffs and subsidies, and economic policies
Imperfect competition
Nontraded goods
Unemployed resources
Factor of production are not homogeneous
Technology is not identical
…
Factor Endowments and
the Heckscher-Ohlin Theorem
 Despite
the limitations, the H-O model provides some
helpful insights into the likely impact of trade on
relative factor prices




Trade based on comparative advantage should tend to
increase the demand for the abundant factor and ultimately
exert some upward pressure on its price
With earning from trade, countries can import needed goods
The same result would obtain with respect to commodity
prices and factor prices if factors were mobile between
countries and final products were immobile internationally
Conclusion: goods movements and factor movements
are indeed substitutes for each other
Factor Endowments and
the Heckscher-Ohlin Theorem

The Stolper-Samuelson Theorem and Income
Distribution Effects of Trade in the HeckscherOhlin Model
 It
explains that with international trade, changes of
factor price will have income distribution effects in
general




Assume a labor abundant country participate the trade
Its labor price will increase and capital price will decrease
Thus, its labor’s total nominal income will increase and
capital’s total nominal income will decrease
Real income is not the same as nominal income, it depends
not only on changes in income, but also on changes in
product prices
Factor Endowments and
the Heckscher-Ohlin Theorem

If workers only consume labor intensive export
good, whether their real income increase or
decrease?
Depends on which increased relatively more than others,
income and commodity price
 Wage = MPL X P
 Both wage and P is increase
 With trade, because wage rate increase, then less labor
will be used in production, thus increase the productivity
of labor at the margin, that is to say, MPL increase
 Conclusion: wage rate in the labor abundant country will
rise relatively more than the price of the export good.
Similarly, the real income of the owners of the scarce
factor is decreasing with trade

Factor Endowments and
the Heckscher-Ohlin Theorem
 Stolper-Samuelson
theorem: with full employment
both before and after trade takes place, the increase
in the price of the abundant factor and the fall in the
price of the scarce factor because of trade imply that
the owners of the abundant factor will find their real
incomes rising and the owners of the scarce factor
will find their real incomes falling
 Owners of the relatively abundant resources tend to
be “free traders” while owners of relatively scarce
resources tend to favor trade restrictions
Factor Endowments and
the Heckscher-Ohlin Theorem
 In
real world, we may not see the clear-cut
income distribution effects with trade
Personal income distribution also depends on
ownership of the factors of production
 Individuals or households often own several
factors of production
 Thus, the final impact of trade on personal income
distribution is far from clear


Concept Check on P139
Theoretical Qualifications to
Heckscher-Ohlin


We need to examine strict assumptions of H-O
and to determine the impact of their absence
Demand Reversal
 H-O:
tastes and preferences are identical in the
trading countries
 Real world: each country may value the products in
very different ways and extreme example is referred
to as demand reversal
Theoretical Qualifications to
Heckscher-Ohlin




Country I: capital abundant, but (PC/PS)I<(PC/PS)II
After trade, country I will export cloth and import steel from
country II
It will cause the relative price of capital to fall in country I and that
of labor to fall in country II
It could interfere with factor price equalization
Theoretical Qualifications to
Heckscher-Ohlin

Factor-Intensity Reversal
 H-O:
a commodity is always relatively
intensive in a given factor regardless of
relative factor prices (the strong-factorintensity assumption)
 In real world: the degree of substitution
between the two factors is sufficiently different
between industries so that we cannot
guarantee that a given product will always be
relatively intensive in the same factor
Theoretical Qualifications to
Heckscher-Ohlin



L and K can be substituted for each other more easily in cloth
production
At (w/r)1, capital is relatively expensive, the K/L ratio represents
that steel is the capital-intensive product
At (w/r)2, cloth is the capital intensive product
Labor is more expensive
(in another country)
(w/r)1< (w/r)2
Capital is more expensive
(in one country )
Theoretical Qualifications to
Heckscher-Ohlin
 If
(w/r)1 applies to country I (labor abundant) and
(w/r)2 to country II (capital abundant), what will
happen?

Both export cloth……???
 Factor-intensity
reversal occurs when a commodity
has a different relative factor intensity at different
relative factor prices
 Factor-intensity reversal could also interfere with
factor price equalization


One of the country can end up exporting the good that
intensively uses its relatively scarce factor
For country I, if it import cloth, labor price will decrease and
capital price will increase just like country II, so (w/r) will
move in the same direction instead of converging toward
each other
Theoretical Qualifications to
Heckscher-Ohlin

Transportation Costs
 H-O:
no transportation costs
 In real world: definitely has transportation
costs
 Assume two country: Norway and France; two
autarky price for corn: PF<PN; France attempts
to pass the entire transportation cost on to
Norway
Theoretical Qualifications to
Heckscher-Ohlin



Without transportation cost, the quantity for trade should be Q1Q2
and q1q2
With transportation cost, PN rise and imports fall thus France export
fall, PF fall. Consequently the quantity move to Q1’Q2’ or q1’q2’
The difference between the price of corn in the two countries will
equal exactly the transportation costs involved
Theoretical Qualifications to
Heckscher-Ohlin

The participating countries will not necessarily share the
transportation costs equally



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


The incidence of the transportation cost will depend on the
elasticities of supply and demand in each country
Conclusion: Who inelastic, who pay more transportation cost
Transportation costs had demonstrated a downward trend
because of new transport technologies and emerging marketing
concerns
Transport time is important as well as distance
The implications of transportation costs do not alter H-O
conclusions about the composition of trade, although the
amount of trade and specialization of production will be reduced
Under this situation, relative factor prices will not equalize and
complete factor price equalization cannot be attained.
If transportation costs are sufficiently large, they can prevent
trade from taking place and lead to the presence of nontraded
goods
Theoretical Qualifications to
Heckscher-Ohlin

Imperfect Competition



H-O: perfect competition
In the real world: imperfect competition,
eg. Monopoly
Example I: the monopolist maintains the
monopoly position at home (price setter)
but at some point chooses to export at
world prices (price taker)




For production: MR=MC P0 and Q0
In the world market: MR=MC PINT and Q1
Sold in the domestic market: Q2 and P2
and Q1Q2 export
International trade leads to an increased
difference between the domestic price
and the world price, not a convergence
to a single commodity price
Theoretical Qualifications to
Heckscher-Ohlin
 Example
2: pure monopolistic price discrimination to
international trade



Single world supplier and the markets in the various
countries can be kept separate and elasticities of demand
differ between the various markets
Assume: two markets, MC constant
MR=MC, a higher price will be charged in the market where
demand is less elastic
Less elastic
More elastic
Theoretical Qualifications to
Heckscher-Ohlin
Pure price discrimination leads to the charging of
different prices in different markets and tends to
reduce the degree of factor price equalization that
takes place
 Several major suppliers may band together and
form a cartel (as only supplier in the market)

Theoretical Qualifications to
Heckscher-Ohlin

Immobile or Commodity-Specific Factors
 H-O:
factors are completely mobile between different
uses in production within a country (permit production
adjustments move smoothly along the PPF according
to product price changes)
 In real world: it is not easy or even possible for factors
to be moved from the production of one product to
another
 Analyze adjustment in short run through the specificfactors model
Theoretical Qualifications to
Heckscher-Ohlin
 SF
model: an attempt to explore the implications of
short-run factor immobility between sectors in an H-O
context



Three factors: labor (mobile), capital in industry X, and capital
in industry Y
Assume: in short time, it is not possible for KX moved to KY
In the SF model, the contract curve is the horizontal line
point A
Theoretical Qualifications to
Heckscher-Ohlin
The different contract curves will be associated
with different PPFs
 RA’S and TA’V
 Considering A to B, and A to C
 The SF PPF will lie inside the normal PPF except
at point A (compare B and C point)

Theoretical Qualifications to
Heckscher-Ohlin
 Implications


for trade:
Suppose country located A and labor intensive in autarky
In H-O model



after trade, move from A to B and result in labor price increase
and K/L increased in each industry, and thus productivity and
wages rise
The flip side of the rise in wages is the fall in the real return to
capital
Policy implications: the country’s abundant factor prefers free
trade to autarky and the country’s scarce factor prefers autarky
to free trade
Theoretical Qualifications to
Heckscher-Ohlin

In SF model, move from A to C




About return to labor, the money wage for labor rises does not
mean its real wage rises




The increased demand for labor will increase the money wage of all
labor
However, the increased demand for capital will face fixed capital supply
which result in the return to capital rises in X (specialize in X
production). Similarly, the return to capital decreased in Y
Policy implication: owners of capital in industry Y will argue against free
trade, while those in industry X will argue in favor of it
Consider money wage in industry X, W=PX MPLX
MPLX decreased (more labor with same capital) thus w/Px fall which
means money wages haven’t risen as much as the price of good X
The direction of the real return for a worker therefore depends on
the bundle of goods being consumed
Concept Check on P149
Summary

To introduce the relationship between labor
standards and comparative advantage

To research the relevance of supply, demand,
and autarky prices

To explain the factor endowments and the
Heckscher-Ohlin Theorem

To understand the theoretical qualifications to
Heckscher-Ohlin