International Trade 0706840 Professor John Struthers

1. To what extent is it valid to argue that the main advantage of the Heckscher-Ohlin (H-O) theory of international trade over that of the Ricardian one of comparative advantage is that H-O is better able to handle changes in the quantities of factors of production ?

The Heckscher-ohlin theory of trade is a general equilibrium model. It expands on the Ricardian model by introducing a second factor of production. Where Ricardo assumed different technologies and levels of technology between countries, Heckscher and Ohlin instead rely on identical production functions where goods are homogenous such that they would be indistinguishable across all firms. This assumption is made explicitly to neutralize the possibility that trade is based on international technological variations in favour of the possibility that trade is based solely on differences in supplies of capital and labor. So the H-O is set up as an alternative to the Ricardian model (Kenen et al, 1995).

Ricardos Comparative Advantage model allowed for a very narrow analysis on trade. By restricting us to one factor (labour) we can only summate a partial equilibrium. With the H-O model, adding a second factor to the analysis yields a deeper and more realistic explanation of trade. The 2x2x2 model incorporates trade between two countries trading two goods produced in free trade rather than complete specialization. This is because countries tend not to devote most of their resources to the production of a particular commodity (Markusen et al, 1995). 1 So in the HO model, comparative advantage and trade are determined by national differences in factor endowments.

To asses the effectiveness of how the Ricardian model handles changes in the quantities of factors we can study a principal determinant of gains from trade which is the economic size of countries, measured in terms of either their factor endowments or their productivity levels. As the production frontier moves further from origin, the country is economically growing bigger. In a thought experiment, Markusen et al equate the change of endowment of labour to an improvement in technology. Thus in a two-country two-good Ricardian model, shifting the
1

Unless the countrys specialization relates to the overwhelming endowment of natural reserves. However because this does not concern relative labor productivity, the Heckscher-Ohlin model is appropriate here too.

production frontier away from origin of the foreign country (F) by an increase in labour results in an increase in Fs exports. However assuming that no change takes place in Home country H, world price ratio (p*) can no longer be at equilibrium. An excess supply is created because Country Hs demand for good X will not have changed but Country F will want to export more of good X. This would pull p* down as shown in Figure 1. Subsequently there will be a deterioration of the Terms of Trade for country F if it is the larger country. The smaller country H will benefit from a relative price increase in Hs export good.

Because the H-O model assumes identical technologies, constant returns to scale and common tastes, the only meaningful difference between countries is that they differ in their relative factor endowments to scale. Also assumed is that the second factor introduced will be capital, there are no market distortions and a single wage rate and a single rental rate on capital prevail within each economy but capital and labour are assumed immobile between borders. These assumptions make a direct comparison with the above example of the Ricardian model mapping changes to a partial

equilibrium a bit difficult. However they (the assumptions) allow the H-O model expansive explanatory power of the effects on the wider economy.

The H-O model itself takes the form of two variants; Fixed capital-labour ratios where endowment changes are exogenous and Variable proportions where the capital-labour ratio can adjust to changes in the wage rate for labour and rental rate for capital. We use the Fixed ratio for deriving important fundamental theorems of the H-O model and for a more realistic analysis we use the exogenous system available in the Variable ratio. When studied under autarky equilibrium, we find that unlike Ricardian, absolute country size is irrelevant for the determination of comparative advantage by virtue of constant returns and identical, homogenous tastes. What matters are relative endowments and factor intensities2.

Figure 2: Autarky Equilibrium

Figure 2 shows the original production possibility frontiers (PPF) for the two countries and two indifferent curves, reflecting identical and homogenous preferences that determine the autarky equilibrium points. This is a fixed ratio PPF and it provides the basic framework for the

Factor intensity is a comparison of production processes across industries but within a country.

Rybczynski Theorem which is concerned with the relationship between the changes in factor endowments and changes in the outputs of the two commodities when commodity prices are assumed to be given. The theorem states that, given unchanged relative commodity prices and assuming that both commodities continue to be produced, an increase in the endowment of one factor will increase the output of the commodity that uses that factor intensively and will reduce the output of the other commodity. This means that the Rybszynski theorem has important implications for the effects of changes in endowments on production possibility curves and the Rybszynski line R in Figure 3 shows how output changes as one factor endowment changes with given commodity prices.

Figure 3

The immediate importance of this simple theorem is in its application to a country open to international trade whose relative goods prices are determined by international markets. It shows how differential rates of growth in factor supplies are consistent with changing comparative advantage which adds a dynamic to the H-O theory.

In the H-O theorem we open the fixed ratio model to international trade and allow for endogenous changes so that we can use a variable ratio model. When countries begin to trade, their trade patterns coincide with shifts in purchasing goods from the higher priced market to the lower priced market. This resulting change in demand also implies a shift in production according to the comparative advantages of each country and this process will continue until the excess demands and supplies for both countries have been satisfied. At some intermediate level p* price ratios will be equalized and trade will result in the equalization of commodity prices where both countries will be producing beyond their PPCs. What we can gather from this entire theorem is that a country will export the commodity that intensively uses its relatively abundant factor. It is clear then that the defining characteristic in this model is that countries are distinguished by their relative supplies of capital and labour. It argues quite simply that growth is more easily sustained in open economics than in closed ones because a potential decline in the marginal productivity of capital can be offset by a shift towards capital intensive goods. A significant proposition here is that a local market for factor services can transform into a global market when local factor services are sold abroad.

However the H-O Theorem does not hold true through empirical evidence as seen in the Leontief Paradox3, and a prime reason for this discrepancy according to Mankiw (2007) is that capital is highly mobile across borders. So the validity of the statement of H-O models main advantage of Ricardian is debatable because in the light of the Leontief Paradox, the assumption of changing technological differences in Comparative Advantage becomes more appealing against empirical evidence.

Leontief (1953) disproved the conclusion of the H-O Theorem when he found that the USA had a lower K/L ratio in exports than in imports despite having the worlds highest K/L ratio.

The H-O Theorem demonstrates the possibility that the pattern of comparative advantage and international trade is determined by national differences in relative factor endowments. It should be evident that trade must, as a result, influence the prices of productive factors. The Factor Price Equalization theorem (FPE) investigates this relationship in detail. This unique relationship can be written as w/r = G (px/py)4 G is a function that depends only on the production functions for the two commodities. With production functions assumed to be identical between countries, G would also be identical. There are two immediate implications. First, because pf < ph in autarky by virtue of the H-O theorem, it must be that wf < wh in autarky as well5. Second, given the fact that free trade equalized the commodity price ratio between countries, the wage-rental ratio will also be equalized. The equalization of these factor returns means that the relative wage must rise in F and fall in H in the movement to free trade. In other words, if the ratio of commodity prices is equal in two countries, then the wage-rental ratio will also be equal, so long as both countries produce both goods. What can be extrapolated from this is that the capital-labour ratios employed in countries X and Y will be the same in both countries as well which implies that the marginal product of labour and capital will be equalized in both nations. And so it follows that real factor prices will be equalized by trade as well. And strongest implication of this model is that labourers and capital owners would have identical living standards in all countries. There would be no economic incentives for factors to migrate. Finally, commodity trade acts as a complete substitute for trade in factors if it results in the factor-price equalization.

In the real word however we do not observe workers enjoying identical living standards in all nations (Markusen et al, 1995). And while the assumptions of FPE theorem (and to a larger
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Refer to equation dynamics in Appendix. This statement illustrates the danger of treating specific variables as exogenous in a general-equilibrium model. Instead it could have been stated that different autarky factor prices are the source of different autarky goods prices, which seems logical.

extent the H-O model) fail, the conclusions that we draw forth add both complexity and insight into isolated circumstances. This is advantageous because the existing variables in the real world are dynamic and hard to measure at one instance (Leamer, 1995). Isolating the events can help us understand the specific impacts of particular variables.

So while in the real world we need to account for significant and changing transport costs, trade restrictions, market distortions, differences in returns to scale and product differentiation, the FPE theorems strength lies in utilizing the framework of a model that explains equilibrium movements under free trade to show how prices, wages and rents will react in a vacuum. An important corollary is that if barriers to trade prevent the equalization of real incomes, there will be incentives for labour and capital to migrate internationally. The unskilled-labour-scarce country will then be required to employ barriers to immigration in order to protect the income of domestic workers. Accordingly, we can point to trade as an important source of the growth in real wages in countries such as Korea relative to that in the United States and it helps explain highwage economies seeking protection against labour-intensive imports. In that vein, the H-O model could be considered as the foundation of international trade as it is clear that trade can result in strong tendencies in the direction posited by the FPE theorem. This is true especially for differences in relative factor endowments. This interindustry trade tends to be prevalent between the developed countries, on one hand, and the developing countries, on the other hand, where there are marked differences in factor supplies and factor prices. In this context, trade tends to equalize real incomes of similar workers and capital owners.

Wolfgang Stopler and Paul Samuelson created a theorem in which the principle purpose was to show that changes in commodity prices have determinate effects on real factor rewards. That is, movements in the prices of goods change the distribution of real incomes between capital and labour, which is an important element in the economy. Specifically, a relative increase in the

price of labour-intensive good X causes the real wage rate to rise whereas the real return on capital must fall. So w/px and w/py increase and both r/px and r/py decrease when px/py increases. What we thus gather is that if there are constant returns to scale and if both goods continue to be produces, 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.

Figure 4: Graphical Representation of Stolper-Samuelson theorem

Source: International Trade: Theory and Policy, Steve Suranovic The implication of this theorem is that in increase in the relative price of good X may be equivalently stated as a larger percentage increase in the price of X than of Y when both nominal prices are subject to change. This change will result in a percentage rise in the wage that is larger still than the higher price increase (because w/px must increase) and a percentage rise in the nominal price of capital that is smaller than the lower price increases (because r/py must fall).

So in relative terms the factor prices change more than commodity prices in order to get determinate effects on real factor incomes. In trade theory this is referred to as the magnification effect.6 Although the Stopler-Samuelson theorem as discussed is not particularly exclusive to international trade, we can use this theorem to investigate the effects of international trade on factor incomes. We subsequently find that the abundant factor in each nation is made better off by free trade, and the scarce factor is made worse off. The reason for this outcome is that trade in goods compensates for national scarcities in factor supplies. Each country exports the services of its abundant factor, resulting in a higher demand for that factor, while it imports the services of its scarce factor, generating a fall in demand for that factor. Markusen et al (1995) note that each country would make aggregate gain in welfare but now there is a redistribution effect from free trade where the abundant factor earns more than the total gains from trade, making the scarce factor worse off. This consequently highlights an important difference between the Ricardian model and the H-O model where in the former all workers share equally in the gains from trade and in the latter case, only the abundant factors gain directly from free trade a more realistic observation.

The assertion that the H-O model handles changes in factor endowments better than the Ricardian model of comparative advantage is debatable given empirical evidence of Deardorff, Leamer and Debeare. Yet the H-O model enables us to reach a deeper level of analysis on international trade through the effects of changes in the commodity prices on real factor prices and the effects of changes in factor endowments on commodity outputs. It is here that the framework of the H-O model gives us theoretically appealing implications and like the Stopler-Samuelson, Rybczynski and FPE theorems, provides the basis to reach empirically sound economic trends. Appendix

Jones (1965). Proof in Appendix.

Given a rise in the price of labour-intensive Good X, the economy would move to produce more of this and less of capital-intensive Good Y. During this adjustment the capital-intensive sector Y would release resources in a bundle involving a higher ratio of capital to labour than the labour-intensive sector X would choose to employ at initial factor prices. Accordingly there would emerge an excess demand for labour and an excess supply of capital, causing a rise in relative factor prices (w) sufficient to establish a new equilibrium. So an increase in the relative price of a commodity will increase the relative return to the factor used intensively in that industry.

A simple proof that a rise in the relative price of X is equivalent to a larger percentage rise in its price is as follows: Let both px and py rise but (px1/py1) > (px0/py0). Rearranging this inequality and subtracting 1 from each side, it follow immediately that [(px1 px0)/px0)] > [(py1 py0)/py0]

Bibliography
Leamer, Edward E. (1995). The Heckscher-Ohlin Model in Theory and Practice. Princeton Studies in International Finance. 77. Princeton, NJ: Princeton University Press. Deardorff, A.V. (1979). 'Weak links in the chain of comparative advantage', Journal of International Economics, vol. 9, pp. 197-209. Debaere, P. and Demiroglu, U. (2003). 'On the similarity of country endowments', Journal of International Economics, vol. 59, pp. 101-136. Duchin, Faye (2000). International Trade: Evolution in the Thought and Analysis of Wassily Leontief. Mankiw, N. G. (2007), Ricardo vs Heckscher-Ohlin, Random Observations for Students of Economics. Markusen , J. R., Melvin ,J. R., Kaempfer, W.H, Maskus, K.E. (1995), International Trade: Theory and Evidence, McGraw-Hill, Inc. Suranovic, S. (2009). International Trade: Theory and Policy, Flatworld Knowledge.