Chapter 4 Factor Endowments and Hecksher-Ohlin

1. Chapter 4 Factor Endowments and Hecksher-Ohlin Yanan University Finance and Economics Dep. Aihong Qin

2. Comparative advantage based on factor endowments Factor prices how they are influenced by trade Trade causing income disparities between skilled and unskilled wages

3. Introduction • A nation will export the commodity whose production requires the intensive use of the nation’s relatively abundant and cheap factor and import the commodity whose production requires the intensive use of the nation’s relatively scarce and expensive factor •  NB: classicals explained using labour as a factor only -Productivity of labor

4. Assumptions • 1.Two Nations(1&2), 2commodities(X&Y),two fators(L&K)- for illustration and comparison • Same technology used-access &same pdn techniques-if factor prices were same in both nations producers will use the same amount of K&L but prices differ, resulting in the use of a cheap factor • X-L-intentive,Y-Capital intensive • Constant returns to scale- ↑K or L in either nation by a certain proportion then output ↑ by same.

5. Assu • Incomplete specialization- even with free trade both counties will continue to produce- No small country assumption • Equal taste in both nations-Demand preferences are identical. Consumption of X&Y will be uniform if relative commodity prices • Perfect competition- Neither producer can influence the prices in these nations

6. Assumptions • In the L-R, commodity prices equal their cost of production-no economic profit after cost • Internal factor mobility- Mvt within ONLY-from areas and industries of lower earnings to areas of higher until earnings are uniform • No transport cost, tariffs, all other barriers to trade • All resources are fully employed –no unutilized factors of pdn • Balanced international trade btwn 2 nations- Exports=Imports.

7. Factor Intensity • Implies that relatively more of one of the factors is used. • With X&Y as commodities of pdn , Y is capital intensive if Capital-Labour(K/L) ratio used in the production used in the pdn of Y is greater than K/L used in the pdn of X. • It is not the absolute amount of capital and labour used in pdn of X &Y- but amount of capital per unit of labour.

8. Factor Intensity

9. Nation 1&2 • Capital-Labour Ratio=1 for Y and ¼ for X. , therefore Y is capital intensive. • Nation2: K/L =4 for Y and and 1 for X thus Y is capital intensive. • NB Its at all possible relative factor prices.

10. Factor Abundance • Def: 2 WAYS • 1. Interms of physical units- total amount of labour capital and labour available in each nation. • 2.interms of Relative factor prices- rental price of capital and price of labour in each nation • Physical units we say there factor abundance if ratio of total amount of capital to the total amount of labour is greater than another nation TK/TL>TL/TK. • Not absolute ???? • Factor prices a nation is capital abundance if the ratio of the rental price of capital to the price of labour is lower in Nation 2 than 1.

11. Factor Abundance& Production Frontier

12. FA cont • Nation 2 which is capital abundant will produce good Y which is capital intensive.vise versa.

13. Hecksher –Ohlin Theory • Originated from “ The Effect of foreign trade on the Distribution of Income”.1991 by Eli Hecksher • The idea was popularised and further built, clarified by Bertil Ohlin in 1933 in a famous bk “Interregional and International Trade.” • Divided into two theorems • 1. H-O theorem- deals with and predicts the pattern of trade • 2.Factor – price equalization- which deals with effect of international trade on factor prices.

14. H-O Theorem • Based on assumptions highlighted above • It states that a nation will export the commodity whose production requires the intensive use of the nation’s relatively abundant and cheap factor and import the commodity whose pdn requires the intensive use of the nation’s relatively scarce and expensive factor. • Theorem emphasizes that relative factor endowments and factor abundance is the primary cause of differences in comparative advantage • A.k.a Factor- proportions or factor endowments theorem.

15. General Equilibrium

16. General Equilibrium • ·      Differences in distribution of ownership of factors of production(income) and taste leads to differences in demand of final commodity prices • Leads to dd of factors of pdn-derived dd • Dd of factors and Supply of factors give rise to factor prices • Factor prices and technology will lead to commodity prices

17. H-O

18. Explanation • Autarky –Nation 1 produces @A and more of X-Labour intensive good -Nation 2-produces at A’ and more of Y capital intensive good • IC 1 passes thru A&A’ • PA less than PA’ • With trade • Nation1 specialises in X and moves from A to B • Nation2 specailises in Y and moves from A’ to B’

19. HO • Therefore Nation 1 will export BC of X and Inport C’B’ of Y • New IC both nations will benefit. • If ratio of Px/Py greater than Pb then Nation 1 wants to export more of commodity X than what Nation2 wants at a higher relative priceof X and then Px/Py falls toward Pb

20. Factor-Price Equalization • International trade will bring about equalization in the relative and absolute returns to homogeneous factors across countries • International trade will cause the wages/return of homogeneous labour/capital- relative and absolute wages and return will be equal. • A labour intensive nation will produce more of X and therefore DD for labour increases raising wages and decreasing interest.

21. F-PET

22. F-E • Shows that w/r1 and w/r2 will move towards w/r* as more labour is demanded in Nation 1 and as more capital is demanded in Nation 2

23. Effects of Trade on the Distribution of Income • Real income of labour rises in Nation1 which is labour abundant, as wages rise and real income of capital rise in Nation 2 as interest rise

24. Empirical Testing • No- in real world homogeneous factors do not receive the same returns. e;.g Engineers in America and SA • Why- some assuptions are not real e.g same technology , no tansportation cost, no trade barriers, existence of imperfect competition, non constant returns to scale

25. Empirical Testing-Leontief Paradox • Using US data for 1947, Wassily Leontief in 1951 tried to test the Heckscher –Ohlin Theory. • US as the most K-abundant nation in the world , Leontief expected that the US expoerted K-Intensive commodities and imported L-intensive commodities. • Using Input-Output table – estimated K/L for US import substitutes rather than imports- as the data on imports was not available • Results showed that US import substitutes were about 30% K intensive than US exports. US exported more L-intensive goods and imported capital intensive goods.

26. Leontief • Leontief explained the results arguing that since US labour was 3 times productive than foreign labour , therefore US was labour intensive- ,an explanation rejected by even Leontief himself later • Another explanation was based on taste- US taste was biased towards K-intensive goods= but taste are similar across nations.

27. Explanations of the Leontief and H-O • 1947 not a good year since it was after WW2 • Use of a two factor model, L&K only leaving natural resources • Tariffs-a tax on imports which stimulate production in the domestic economy. • Use of only physical capital leaving human capital

28. Factor -Intensity Reversal • Refers to a situation where a given commodity is the L-intensive commodity in the L- abundant nation and K-intensive commodity in the K-abundant nation.e.g if X is L-intensive commodity in N1(Low wage), and at the same timeit is K-intensive in N2(high wage nation) • We use the concept of elasticity of substitution which measures the degree or ease with which one factor can be substituted for another in the pdn as relative price of the factor declines. • If elasticity of L for K is much greater in pdn of X than Y- it means that its much easier to substitute L for K in the pdn of X than Y

29. Factor-Intensity reversal is more likely to occur the greater the difference in the elasticity of substitution for L &K in the pdn of two commodities • Factor –Intensity Reversal results in the invalidity of H-O and factor-price equalization. • H-O fails to hold as a L-abundant nation cant export a capital –intensity commodity.