3.

Heckscher-Ohlin Mode of Trade

Heckscher-Ohlin Model

1. Setup
2. Autarky Equilibrium
3. Free Trade Equilibrium
4. The Heckscher-Ohlin Theorem
5. The Factor-Price-Equalization Theorem
6. The Stolper-Samuelson Theorem
7. The Rybczynski Theorem

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3.Heckscher-Ohlin Mode of Trade

Problems with Ricardian model:

1. It predicts complete specialization
2. It predicts that all workers will gain from free trade. In real life
some workers oppose free trade. (E.g. U.S. steel workers oppose
free trade with China)

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3.Heckscher-Ohlin Mode of Trade

Heckscher-Ohlin Model:
2 factors: capital (K) and labour (L) => concave production
frontier => no complete specialization, in equilibrium each
country produces both goods
Comparative advantage is based on national differences in factor
endowments. Countries have different factors endowments (e.g.
capital, labour (skilled or unskilled), land etc.) Differences in
relative factor endowments result in differences in autarky
prices. E.g. countries that have relatively abundant supplies of
agricultural land (like Canada, USA) have cheaper autarky prices

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of agricultural products and become exporters of agricultural

products.

The model predicts that trade leads to redistribution of income

between capital and labour => explains opposition to trade of
some factors of production

This model is favoured by economists and is supported by the

real world data. There is a great deal of evidence that differences
in factor endowments are important in explaining trade patterns.

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3.Heckscher-Ohlin Mode of Trade

1. Setup
2 goods:

X,Y

2 factors:

K,L, capital gets rent r, labour gets wage w

2 countries:

H,F

Assumptions
1. Identical CRS production functions in H and F
2. Kh, Lh, Kf, Lf - fixed factor endowments
factors are perfectly mobile within each country between X
and Y sectors;

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3.Heckscher-Ohlin Mode of Trade

factors are immobile between countries.

3. H, F differ in relative factor endowments. (This will give rise to
price differences in H and F.)
4. Consumers in H, F have identical, homogenous preferences
5. No distortions (tariffs etc.)

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3.Heckscher-Ohlin Mode of Trade

Definition
Factor Endowments
If capital- labor ratio in country H is greater than it is in country F

Kh K f

( Lh
L f ), then country H is relatively capital-abundant and
labour-scarce, while country F is relatively labour-abundant and
capital-scarce.

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3.Heckscher-Ohlin Mode of Trade

Example
K stock

($b.)

(m)

K
L
($)

Brazil
US
Switzerland

507

53

9, 566

3,696

116

32,421

120

40,000

=> U.S. is capital-abundant relative to Brazil, but capital-scarce

relative to Switzerland.

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3.Heckscher-Ohlin Mode of Trade

A. Factor Endowments Graph

H is capital-abundant, F is labour-abundant
Eh

Kh

slope=home capital-labour ratio

Ef
Kf

slope=foreign capital-labour ratio

L
Lh

Lf

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3.Heckscher-Ohlin Mode of Trade

Definition
Factor Intensities
Good Y is relatively capital-intensive and good X is relatively
labour-intensive if the capital-labour ratio used in production of

Ky

Kx

good Y is higher: L y
Lx

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3.Heckscher-Ohlin Mode of Trade

Example
K $m

K
L

,$

thousands
Petroleum 27,005

95

284,263

Footwear

107

4,804

514

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3.Heckscher-Ohlin Mode of Trade

Take some price ratio w/r. Producers minimize costs => isoquant is
tangent to w/r. For any price ratio, at optimum

K
K
) y ( )x
L
L

=> good

Y is relatively capital-intensive, X is relatively labour-intensive.

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3.Heckscher-Ohlin Mode of Trade

B. Factor Intensities Graph

Y is capital-intensive, X is labour-intensive

Ky

Y
slope=Ys capital-labour intensity
Kx

X
slope=Xs capital-labour intensity

w
r

L
Ly

Lx

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3.Heckscher-Ohlin Mode of Trade

Assume:
1. Country H is relatively K-abundant, country F is relatively Labundant
2. Good Y is K-intensive, X is L-intensive
Yh , X h , Y f , X f

- maximum amounts of goods X, Y that H, F can

produce (i.e. if all resources are devoted to production of one

good)

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3.Heckscher-Ohlin Mode of Trade

Result
Yf
Yh

Xh X f

I.e. capital-abundant country can produce relatively more of

capital-intensive commodity.
Can be shown in 2 steps:

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3.Heckscher-Ohlin Mode of Trade

Step 1. Assume that H, F are similar:

K

A. Factor Endowments Graph,

Isoquants for Y and X

Yh

H is capital-abundant, F is labour-abundant
Eh
Kh

Yf
Kf
Ef

Xh

Xf

L
Lh

Lf

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3.Heckscher-Ohlin Mode of Trade

Commodity Space, Home and Foreign PPFs

Y
Yh

Home PPF

Yf

Foreign PPF
X
Xh

Xf

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Yh Y f ; X h X f

Step 2. CRS technology =>

=>
Yh Y f
,
Xh X f

Yf
Yh

Xh X f

are independent of sizes of the

countries.
Let X f x ( K , L ),

Y f y (K , L )

be maximum amounts of goods X

and Y that can be produced.

A country grows and now has 3 times more capital and labour. The
outputs of X and Y are:
f x (3K ,3L ) 3 f x ( K , L ) 3 X

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3.Heckscher-Ohlin Mode of Trade

f y (3K ,3L ) 3 f y ( K , L ) 3Y

X
before growth, the ratio was Y ; after growth, the ratio stays the
3X X
same: 3Y = Y .

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3.Heckscher-Ohlin Mode of Trade

Commodity Space, PPFs

Y
Yh

Home
PPF

2Y f

Yf

1
Yh
3

Foreign PPF

1
Xh
3

Xf

Xh
20

2X f

X
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3.Heckscher-Ohlin Mode of Trade

=> Independently of country sizes, PPF of a relatively capitalabundant country will be more stretched along the K-intensive
axis.
2. Autarky Equilibrium
Assume: H is capital-abundant country and Y is capital-intensive
good.

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3.Heckscher-Ohlin Mode of Trade

Autarky
Y
Yh
Ah

Home
PPF
Yf

u ah

Af

P
h

u af

P
f

Foreign PPF
X
Xh

Xf

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Note: Identical homogenous preferences => H and F have parallel

indifference

curves.

Home

and

foreign

production

and

consumption in autarky are at Ah and Af.

Tangency between the PPF and indifference curve determines
autarky price ratios:
Pxh Px f
f
h
Py
Py

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3.Heckscher-Ohlin Mode of Trade

=> Capital-intensive good Y is relatively cheaper in capitalabundant country H, while labour-intensive good is cheaper in
labour-abundant country F.

3. Free Trade Equilibrium

If countries open to trade, H observes relatively cheaper X abroad,
F observe relatively cheaper Y abroad =>
H exports Y (k-intensive good) and imports X, F exports X (lintensive good) and imports Y.
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3.Heckscher-Ohlin Mode of Trade

H produces more Y and less X, and F produces less Y and more X

Note: There is no complete specialization in this model, both

countries keep producing both goods after trade.

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3.Heckscher-Ohlin Mode of Trade

Move from Autarky to Free Trade

Y
Qh*
Yh

Ah

Yf

C h*

u h*

C *f

u hA
u *f

Af
Q

u Af

*
f

P*

P*
X
Xf

Xh
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3.Heckscher-Ohlin Mode of Trade

Trade equalizes prices in 2 countries

H, F produce both goods
Both H and F gain from trade.

4. The Heckscher-Ohlin Theorem

Theorem
The Heckscher-Ohlin Theorem
A country will export the commodity that intensively uses its
relatively abundant factor

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3.Heckscher-Ohlin Mode of Trade

Free Trade, Trade Triangles

Y
Qh*

Hs exports of Y
=

C h*

u h*

*
f

Fs imports of Y

u *f

P*

Q *f

P*
X
Hs imports of X

28

=Fs exports of X

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3.Heckscher-Ohlin Mode of Trade

Note: Empirically HO theorem applies better to countries with

large differences in relative endowments (e.g. USA Mexico
trade). This trade model predicts inter-industry trade.
World price P* adjusts to keep trade balanced: Hs imports of X=
Fs exports of X and Hs exports of Y= Fs imports of Y.

5. The Factor-Price-Equalization Theorem

After countries open to trade each country observes higher relative
price for its exports:
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H: observes higher relative price for Y, exports Y (k-intensive

good), resources are reallocated from sector X to sector Y =>

demand for capital, demand for labour => r and w => w/r
F: observes higher relative price for X, exports X (l-intensive
good), resources are reallocated from sector Y to sector X =>

demand for labour, demand for capital => w and r => w/r

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3.Heckscher-Ohlin Mode of Trade

there is a relationship between prices of goods and factor

prices:
P
w
G( x ) ,
r
Py

such that

Px
Py

=>

w
r .

Note: technology in H, F is identical =>function G(.) is identical in

H,F.
1.In autarky: Ph>Pf =>

w
w
( )h ( ) f
r
r

i.e. labour is relatively cheaper

in labour-abundant country, capital is relatively cheaper in

capital-abundant country.
2.Trade: Ph=Pf =P* =>

w
w
( )h ( ) f
r
r

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Theorem
The Factor-Price Equalization Theorem
Under identical CRS production technologies free trade in
commodities will equalize relative factor prices through
equalization of relative commodity prices so long as both countries
produce both goods.

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2 fundamental relationships:

Change in price P (e.g. change from autarky price Pa to free

trade price P*) => change in factor rewards w,r (The StolperSamuelson Theorem)

Change in endowments K , L => change in outputs of X,Y

(The Rybczynski Theorem)

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6. The Stolper-Samuelson Theorem

Theorem
The Stolper-Samuelson Theorem
If there are constant returns to scale and if both goods continue to
be produced, a relative increase in the price of a commodity will
increase the real return to the factor used intensively in that
industry and reduce the real return to the other factor.

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Assume X is a labour-intensive good. If Px/Py increases, real

returns to workers will increase, while real returns to capital
owners will fall.

Proof:
w w r r
, , ,
Real wages: Px Py Px Py

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3.Heckscher-Ohlin Mode of Trade

SS:

Px
Py

w w
,
Px Py

=>

r r
,
Px Py

Note: in equilibrium, factor price=value of marginal product

Recall labour market equilibrium conditions:
Sector X:

Sector Y:

w Px MPLx

w Py MPL y

r Px MPK x

r Py MPK y

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Real wages:
w
MPLx
Px

w
MPLy
Py

r
r
MPK y
MPK x ;
Py
Px

We have to show that change in relative prices

products in X and Y sectors, so that

Px
Py

Px
Py

affects marginal

=> MPL in both sectors,

and MPK in both sectors.

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2 steps (no rigorous proof required)

Step 1.

Px
Py

=> output of X => demand for labour increases

relative to demand for capital because X is a labour-intensive good

=> w/r labour becomes relatively more expensive => K/L ratio
both in production of X and Y (producers substitute away from
relatively more expensive input).

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B. Factor Intensities Graph: change in w/r

Y is capital-intensive, X is labour-intensive

Ky

Y
Kx

slope=Ys capital-labour intensity

X
slope=Xs capital-labour intensity

w
r

L
Ly

Lx

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(note: homothetic production function: same K/L ratio for all

levels of Y (or X) for any w/r)
Step 2.

K/L => MPL, MPK (because of law of diminishing

returns)
Recall Properties of Production Function:

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Law of Diminishing Marginal Product. If use of L in the

production of X is increasing, total product of labour is
increasing at a decreasing rate.

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Law of Diminishing Marginal Product:

Total Product Diagram

TPx ( Lx , K 2 )

C
B

TPx ( Lx , K1 )

L1

L2

Lx

Marginal Product Diagram

X
C

MPLx ( Lx , K 2 )
- slope of TP curve

MPLx ( Lx , K1 )
- slope of TP curve

L1

L2

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Lx

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3.Heckscher-Ohlin Mode of Trade

1. Increase labour from L1 to L2 keeping capital fixed at

K1 ,

TPL

increases, MPL falls. (Movement from A to B on Total Product

or Marginal Product graph).
2. Keep labour fixed at L1, increase

K2 ,

TPL increases, MPL

increases. (Movement from A to C on Total Product or

Marginal Product graph).
K
)
L :

Generally,

MPL f (

Similarly,

K
MPK f ( ) :
L

K
L

K
L

MPL

43

MPK x ;

K
L

K
L

MPL

MPK

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3.Heckscher-Ohlin Mode of Trade

E.g. if K by 15%, and L by 10% MPL because capitallabour ratio goes up, but MPK falls.

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Application of Stolper-Samuelson Theorem:

E.g. labour-abundant country F (relatively cheap X) enters free
trade with capital abundant country H (relatively cheap Y). As a
result of trade, within each country prices change to the world
price P*.
A

F: P*>Ph =>

Px
Py

=> w/r , workers gain from trade in real terms,

capital-owners lose.
A

H: P*<Pf =>

Px
Py

=> w/r, capital-owners gain, workers lose.

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3.Heckscher-Ohlin Mode of Trade

Country exports services of the relatively-abundant factor =>

increase demand for abundant factor => higher return to abundant
factor.

Relatively abundant factor gains from trade, relatively

scarce factor loses from trade. Trade in HO model has

redistributional effect: there is aggregate gain from trade, but the
gain is incurred by the abundant factor only, while the scarce factor
incurs loses. (I.e. abundant factor gains more that average, while
scarce factor loses.) E.g. unskilled labour is relatively scarce in the
U.S. => workers protest free trade with developing countries and
demand protection.

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7. The Rybczynski Theorem

Theorem
The Rybczynski Theorem
If relative commodity prices are constant and if both commodities
continue to be produced, an increase in a supply of a factor will
lead to an increase in output of the commodity using that factor
intensively, and a decrease in the output of the other commodity

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E.g. immigration => increase in

- one may expect that outputs of

X and Y will both increase. NO! Output of X will increase, output

of Y will decrease. If home country increases its capital stock, it
will produce more of good Y and less of good X.
Y

Growth in Labour Endowment (X is labour-intensive good)

Output expansion
P

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The theorem is important as it predicts the impact of economic

growth on trade. The way in which country growth has an impact
on its production and trade mixes. Countries with low saving rates
but high population growth would tend to produce goods and
export goods with high labour contents. Countries with high saving
and investment rates will produce and export more capitalintensive goods.

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