Chapter 4

Resources and Trade:

The Heckscher-Ohlin Model
Introduction
• In addition to differences in labor productivity, trade occurs due to differences in
resources across countries.

• The Heckscher-Ohlin theory argues that trade occurs due to differences in labor,
physical capital, or other factors of production across countries.

 Countries have different relative abundance of factors of production.

 Production processes use factors of production with different relative intensity.
Two-Factor Heckscher-Ohlin Model
1. Two countries: home and foreign.
2. Two goods: cloth and food.
3. Two factors of production: labor and capital.
4. The mix of labor and capital used varies across goods.  Factor Intensity (Industry
characteristics)
5. The supply of labor and capital in each country is constant and varies across
countries.  Factor Abundance (Country characteristics)
6. In the long run, both labor and capital can move across sectors, equalizing their
returns (wage and rental rate) across sectors.
7. Competition allows factors to be paid a return equal to the value of what they
produce, and allows them to work in the industry that pays the higher return.
Two-Factor Heckscher-Ohlin Model
Structure of Model

Supply Side (PPF and RS) Demand Side (U max and RD)

Closed Economy Equilibrium (1 country)

Free Trade Equilibrium (2 countries) Heckscher-Ohlin Theorem

3 more important theorem

(1) Stolper-Samuelson Theorem  about “trade and income distribution within a country”
(2) Rybczynski Theorem  about “resources and output”
(3) Factor Price Equalization Theorem  about “trade and factor prices across countries”
Production Possibilities
• With more than one factor of production, the opportunity cost in
production is no longer constant and the PPF is no longer a straight
line. Why?

 Intuition using numerical example:

• Numerical example:

K = 3000, total amount of capital available for production

L = 2000, total amount of labor available for production
Production Possibilities
If there is no factor substitution:
• Suppose that there is a fixed mix of capital and labor in each sector.
aKC  2, capital used to produce 1 yard of cloth
Cloth Sector
aLC  2, labor used to produce 1 yard of cloth

aKF  3, capital used to produce 1 calorie of food

Food Sector
aLF  1, labor used to produce 1 calorie of food

Note: This is just an example to explain the non-linear PPF. In the full model of
Heckscher-Ohlin, mixes of capital and labor will be determined as optimal choices.
So, it will be an endogenous variable.
Production Possibilities
• Production possibilities describe different amounts of cloth and food that
can be produced, given factor endowments and technology.

 QC is total yards of cloth production

 QF is total calories of food production

• Labor Supplied (L) and Capital supplied (K) will be allocated to each sector as follows

 LC = aLC ✕ QC and LF = aLF ✕ QF

 KC = aKC ✕ QC and KF = aKF ✕ QF

Production Possibilities
• Production possibilities are influenced by both capital and labor:

 Capital used to produce cloth and food cannot exceed the supply of
capital (K) available.

aKCQC  aKF QF  K 2QC  3QF  3000

 Labor used to produce cloth and food cannot exceed the supply of
labor (L) available.

aLCQC  aLF QF  L 2QC  QF  2000

Production Possibilities
• Economy must produce subject to both constraints—that is, it must have
enough capital and labor.

• If there is no factor substitution between labor and capital, the production

possibilities frontier is the interior of the two factor constraints.

Figure 5.1 (without factor substitution)

• Max food production 1000 (point 1) fully uses capital, with excess labor.
• Max cloth 1000 (point 2) fully uses labor, with excess capital.
• Intersection of labor and capital constraints occurs at 500 calories of food and
750 yards of cloth (point 3).
Figure 5.1 The Production Possibility Frontier without Factor Substitution
LC = 2 ✕ QC and LF = 1✕ QF 2QC  QF  2000
KC = 2 ✕ QC and KF = 3✕ QF 2QC  3QF  3000

(1) If KF = K = 3000,
Then, LF = 1000 should be combined, and available.
 QF = 1000 and QC=0  point 1
 But, labor is not fully used. (1000 work-hours are
unemployed)

(2) QF = 2000 is not possible.

Why? To do so, KF should be 6000, and LF should be 2000.
But, the economy has only K = 3000.

If capital cannot be substituted for labor or vice versa, the production possibility frontier in the factor-
proportions model would be defined by two resource constraints: The economy can’t use more than the
available supply of labor (2,000 work-hours) or capital (3,000 machine-hours). So the production possibility
frontier is defined by the red line in this figure.
Figure 5.1 The Production Possibility Frontier without Factor Substitution
LC = 2 ✕ QC and LF = 1✕ QF
KC = 2 ✕ QC and KF = 3✕ QF

(3) If LC = L = 2000,
Then, KC = 2000 should be combined, and available.
 QC = 1000 and QF=0  Point 2
 But, capital is not fully used. (1000 machine-hours are
unemployed)

(4) QC = 1500 is not possible.

Why? To do so, LC should be 3000 and KC should be 3000.
But, the economy has only L = 2000.

If capital cannot be substituted for labor or vice versa, the production possibility frontier in the factor-
proportions model would be defined by two resource constraints: The economy can’t use more than the
available supply of labor (2,000 work-hours) or capital (3,000 machine-hours). So the production possibility
frontier is defined by the red line in this figure.
 Figure 5.1 The Production Possibility Frontier without Factor Substitution
LC = 2 ✕ QC and LF = 1✕ QF
KC = 2 ✕ QC and KF = 3✕ QF

If the economy produces both Food and Cloth,

then QF = 500 and QC = 750 is possible
and all L and K are fully employed. (Point 3)

For QF = 500, ( LF = 500 and KF = 1500 ) are allocated to F sector.

For QC = 750, ( LC = 1500 and KC = 1500 ) are allocated to C sector.

 So, L = 2000 and K = 3000 are all employed !!!!!

If capital cannot be substituted for labor or vice versa, the production possibility frontier in the factor-
proportions model would be defined by two resource constraints: The economy can’t use more than the
available supply of labor (2,000 work-hours) or capital (3,000 machine-hours). So the production possibility
frontier is defined by the red line in this figure.
 Production Possibilities
• The opportunity cost of producing 1 more yard of cloth, in terms of food,
is NOT constant !!!!!:
Segment
between Point 1  Low opportunity cost (= 2/3) when the economy produces
and Point 3 a low amount of cloth and a high amount of food

Segment
between Point 3  high (=2) when the economy produces a high amount of cloth and a low
amount of food
and Point 2

• Why? Because when the economy devotes more resources towards

production of one good (i.e. cloth), the marginal productivity of those
resources tends to be low so that the opportunity cost is high.
Production Possibilities
• The above PPF equations do not allow substitution of capital for labor in
production.
 Unit factor requirements are constant along each line segment of the PPF.

• If producers can substitute one input for another in the production process,
then the PPF is curved (bowed).
 Opportunity cost of cloth continuously increases as producers make more
cloth.

This is the right PPF of the Heckscher-Ohlin Trade model

That is, Heckscher-Ohlin model assumes the “factor substitutability”
Figure 5.2 The Production Possibility Frontier with Factor Substitution

If capital can be substituted for labor and vice versa, the production possibility frontier no
longer has a kink. But it remains true that the opportunity cost of cloth in terms of food rises
as the economy’s production mix shifts toward cloth and away from food.
Production Possibilities
• The PPF curve is defined as the efficient output combinations (𝑄𝐶 , 𝑄𝐹 ) when the production
functions and the factor endowments are given.

Mathematical Example: Suppose that Cobb-Douglas production functions and factor endowments are
given as follows.
2/3 1/3 1/3 2/3
𝑄𝐹 = 𝐹 𝐾𝐹 , 𝐿𝐹 = 𝐾𝐹 𝐿𝐹 and 𝑄𝐶 = 𝐺 𝐾𝐶 , 𝐿𝐶 = 𝐾𝐶 𝐿𝐶
𝐾 = 𝐾𝐶 + 𝐾𝐹 and 𝐿 = 𝐿𝐶 + 𝐿𝐹

(1) If all K and L are allocated in only one industry,

then 𝑄𝐹 = 𝐹 𝐾, 𝐿 = 𝐾 2/3 𝐿1/3 and 𝑄𝐶 = 𝐺 0,0 = 0,
or 𝑄𝐹 = 𝐹 0,0 = 0 and 𝑄𝐶 = 𝐺 𝐾, 𝐿 = 𝐾 1/3 𝐿2/3.

 These are specialization points in the PPF curve. (see next page)
𝑄𝐹 = 𝐹 𝐾, 𝐿 = 𝐾 2/3 𝐿1/3
and 𝑄𝐶 = 𝐺 0,0 = 0

𝑄𝐹 = 𝐹 0,0 = 0
and 𝑄𝐶 = 𝐺 𝐾, 𝐿 = 𝐾 1/3 𝐿2/3
Production Possibilities
(2) when all K and L are allocated in both industries,

then both goods are produced with positive amounts based on the production
functions.

 What is the shape of all those possible combinations with positive amounts of output?

Answer: the shape is convex as shown in the figure.

This is because of our assumption: “marginal productivity of factors”.

Production Possibilities
The slope of PPF
= Opportunity cost of producing 1 yard of cloth, measured in terms of Food
= Marginal Rate of Transformation (MRT)
𝑑𝑄𝐹
𝑀𝑅𝑇 ≡ −
𝑑𝑄𝐶

Question: As Qc is increased by 1 unit (= 𝑑𝑄𝐶 =1), how many unit of Food should be decreased?
 Answer: 𝑑𝑄𝐹 , which is negative (-). Also, as Qc keeps increasing by 1 more unit (= 𝑑𝑄𝐶 =1), the
unit of Food that should be decreased will be larger. That is, the absolute value of 𝑑𝑄𝐹 should be
larger. (Why? Due to the assumption on marginal production of factors. )

 So, MRT is “increasing” and thus the PPF is “convex” as shown in the Figure.
 Compared to point A,
at point B, production of Food is smaller.
Production Possibilities
 to produce 1 more cloth,
The economy should move labor and capital
𝑄𝐹 from Food industry to cloth industry.
Then, food production is reduced.
𝑑𝑄𝐶 =1
−𝑑𝑄𝐹 is smaller. However,
the reduced amount of Food production is larger.
𝑑𝑄𝐶 =1 (As shown in the figure.)
A
B Why?

At point B, relatively smaller Food production

−𝑑𝑄𝐹 is greater. compared to point A, implies
smaller use of capital and labor.

So, marginal (food) product of labor and capital are

𝑄𝐶 larger.
which means, the amount of Food that is “given up”
become bigger.
Relative Supply Curve
• What does the country produce?  Relative Supply Curve
• The economy produces at the point that maximizes the value of
production, V.
• An isovalue line is a line representing a constant value of production, V:
𝑉 𝑃𝐶
V  PCQC  PF QF 𝑄𝐹 = − 𝑄𝐶
𝑃𝐹 𝑃𝐹
– where PC and PF are the prices of cloth and food.

– slope of isovalue line is PC


PF
Figure 5.3 Prices and Production
𝑉 𝑃𝐶
𝑄𝐹 = − 𝑄𝐶
𝑃𝐹 𝑃𝐹

• As the line moves to the north-east,

the value of V becomes larger.

• Given the PPF and prices,

the “maximum” value of V
can be obtained at point Q.

The economy produces at the point that maximizes the value of production given the prices it faces;
this is the point on the highest possible isovalue line. At that point, the opportunity cost of cloth in
terms of food is equal to the relative price of cloth, PC  PF .
 𝑃𝐶
Suppose that 𝑀𝑅𝑇𝐴 < at point A.
𝑃𝐹 𝐴

A is NOT an optimal choice of output.

𝑄𝐹 𝑃𝐶  The economy cannot achieve the
𝑃𝐶 𝑃𝐶 “maximum” value of V.
𝑃𝐹 = = 𝑀𝑅𝑇𝐵
𝐴 𝑃𝐹 𝐴 𝑃𝐹 𝐵

Then, what will happen?

A  To have the maximum of V, the

𝑀𝑅𝑇𝐴 isovalue line should move the north-east.

B At point B,

𝑃𝐶
= 𝑀𝑅𝑇𝐵
𝑃𝐹 𝐵

𝑄𝐶 So, B is the optimal choice of output.

Relative Supply Curve
• Given the relative price of cloth, the economy produces at the point Q that
touches the highest possible isovalue line.

• At that point, the relative price of cloth equals the slope of the PPF, which equals
the opportunity cost of producing cloth.

 The trade-off in production equals the trade-off according to market prices.

𝑃𝐶
= MRT
𝑃𝐹
= slope of PPF = opportunity cost of producing 1 cloth
Relative Supply Curve
• If the relative price of cloth to food changes in the product markets, the optimal
choice of production should change as well.

If the relative price increases, more cloth and less food are produced along the
line of PPF.

So, the relative supply curve has an upward slope.  see figure in the next page.
Relative Supply curve
𝑃𝐶
𝑄𝐹 𝑃𝐹
𝑃𝐶 RS line
𝑀𝑅𝑇𝐴 =
𝑃𝐹 𝐴

𝑃𝐶
A 𝑃𝐹 𝐵

B 𝑃𝐶
𝑃𝐶
𝑀𝑅𝑇𝐵 = 𝑃𝐹 𝐴
𝑃𝐹 𝐵 𝑄𝐶
𝑄𝐹

𝑄𝐶 𝑄𝐶 𝑄𝐶
𝑄𝐹 𝑄𝐹 𝐵
𝐴
Demand Side
• Same as in the Ricardian Trade Model.

 We assume identical preference of consumers in both countries.

 Utility maximization given the Budget Constraint  Optimal consumption

 Relative demand curve is derived as in the Ricardian model.

Before and after trade, RD line remains unchanged.

Relative Prices and Relative Demand
Consumers’ Utility Maximization Problem  Relative Demand Curve

Max 𝑼 = 𝑼 𝑸𝑭 , 𝑸𝑪 , given 𝐼 = 𝑃𝐶 𝑄𝐶 + 𝑃𝐹 Q 𝐹

1/3 2/3 β 1−β

Example: Cobb-Douglas Utility function  𝑈 = 𝑄𝐶 𝑄𝐹 (or generally, 𝑈 = 𝑄𝐶 𝑄𝐹 )

2 conditions for the Optimal Consumption Choice:

𝑷𝑪 𝑰 𝑷𝑪
= 𝑴𝑹𝑺 and 𝑸𝑭 = − 𝑸
𝑷𝑭 𝑷𝑭 𝑷𝑭 𝑪

Note: MRS (marginal rate of substitution) can be obtained from the utility function as follow.

𝑑𝑄𝐹 𝑀𝑈𝐶 1 𝑄𝐹
𝑀𝑅𝑆 ≡ − = =
𝑑𝑄𝐶 𝑀𝑈𝐹 2 𝑄𝐶
𝑄𝐹
If the Utility function is Cobb-Douglas,
𝑃 1𝑄
then 𝑃𝐶 = 2 𝑄𝐹
𝐼 𝐹 𝐶

𝑃𝐹

𝑃𝐶
𝑃𝐹

𝑄𝐶
𝑄𝐹
[Relative Demand ]
[Utility Maximization]
Relative Prices and Relative Demand
Relative Demand
• The relative demand for goods from this example as follows. (See the Figure)

𝑃𝐶 1 𝑄𝐹
=
𝑃𝐹 2 𝑄𝐶

• Note
(1) The right hand side is nothing but just the MRS. So, the relative demand function can be
obtained from the MRS directly, by equating it with the relative price.

(2) The right hand side (i.e. MRS) is only a function of relative quantity of goods, without
Income level (I).
Closed Economy’s Equilibrium
 Example:
What if the economy is not in equilibrium?
𝑃𝐶
𝑃𝐹
𝑄𝐹
𝑃𝐶
RS
𝑀𝑅𝑆𝐴 =
𝑃𝐹 𝐴𝐵
𝑃𝐶
A 𝑃𝐹 𝐴𝐵
𝑃𝐶
𝑀𝑅𝑇𝐵 =
𝑃𝐹 𝐴𝐵

B RD
𝑃𝐶
𝑃𝐹 𝐴𝐵 𝑄𝐶
𝑄𝐶 𝑄𝐹
𝑄𝐶
𝑄𝐶
𝑄𝐹 𝐴
𝑄𝐹 𝐵
Cloth market: Excess Supply  price of cloth will fall. Eventually, the relative price will fall.
Food market: Excess Demand  price of food will rise.
 Approach to the equilibrium as in the previous page.
Trade in the Heckscher-Ohlin Model
Assumption on 2 trading countries – Home and Foreign

• The countries are assumed to have the same technology and the same tastes.

 With the same technology, each economy has a comparative advantage in

producing the good that relatively intensively uses the factors of
production in which the country is relatively well endowed.

 With the same tastes, the two countries will consume cloth to food in the
same ratio when faced with the same relative price of cloth under free
trade.
Trade in the Heckscher-Ohlin Model
We assume that
Foreign is capital abundant and Home is labor abundant

𝐾 𝐾∗
< ∗
𝐿 𝐿

This assumption makes the following PPF lines for Home and Foreign.
 Max QF*

Max QF

Max QC Max QC*

[Home’s PPF] [Foreign’s PPF]

Trade in the Heckscher-Ohlin Model
Understanding how to identify the PPFs?

(1) Max QC is greater than Max QC* .

 Home is labor-abundant and Cloth is labor intensive. So, given the same production
production for cloth between Home and Foreign, Home’s Maximum production for
cloth should be greater than Foreign’s.

(2) Likewise, Max QF* is greater than Max QF .

Trade in the Heckscher-Ohlin Model
(3) Home has a comparative advantage in Cloth, while Foreign has a comparative
advantage in Food production.

 Home has a lower opportunity cost of producing 1 yard of cloth

 Foreign has a lower opportunity cost of producing 1 calorie of Food

𝜕𝑄𝐹 𝜕𝑄𝐹∗
Or, 𝑀𝑅𝑇𝐴 = − < − ∗ = 𝑀𝑅𝑇𝐴∗
𝜕𝑄𝐶 𝐴
𝜕𝑄𝐶 𝐴

To understand this, consider the following example:

 Example:
suppose that 2 countries are currently producing same amount of cloth and food at point A

To producing 1 more cloth, QF, QF*

which country should give up
less food production ? 𝜕𝑄𝐹∗
𝑀𝑅𝑇𝐴∗ = − ∗
𝜕𝑄𝐶 𝐴
 Home country

Why?
A
Since Home is labor abundant,
At point A, 𝜕𝑄𝐹
Home is using more labor per capital 𝑀𝑅𝑇𝐴 = −
𝜕𝑄𝐶 𝐴
than Foreign.

So, labor productivity is lower in Home,

and higher in Foreign. QC, QC*

Therefore, producing 1 more cloth, Foreign’s food production must be reduced more than Home’s.
Trade in the Heckscher-Ohlin Model
Now, from PPF to Relative Supply Curve

Since cloth is relatively labor intensive,

at each relative price of cloth to food, Home will produce a higher ratio of cloth to
food than Foreign.

So,
• Home will have a larger relative supply of cloth to food than Foreign.
 Home’s relative supply curve lies to the right of Foreign’s.
 Suppose that the price of cloth to food is given for both countries.
 QC/QF in Home is greater than QC*/QF* in Foreign.

𝑃 𝑃𝐶∗
If − 𝑃𝐶 = − 𝑃∗ ∗
𝑃𝐶∗
𝐹 𝐹 𝑀𝑅𝑇 = ∗
QF * 𝑃𝐹
Then,
𝑃𝐶
Each country equates 𝑀𝑅𝑇 =
the price ratio to 𝑃𝐹
MRT, to choose QF
optimal production.

Then,

Home (labor abundant)

will choose to produce QC QC*
more labor intensive good.
[Home’s PPF] [Foreign’s PPF]
 𝑃𝐶 𝑃𝐶∗
, ∗
𝑃𝐹 𝑃𝐹

RS* RS

𝑃𝐶 𝑃𝐶∗
=
𝑃𝐹 𝑃𝐹∗

𝑄𝐶∗ 𝑄𝐶 𝑄𝐶∗
𝑄𝐶 ,
𝑄𝐹∗ 𝑄𝐹 𝑄𝐹∗
𝑄𝐹
Trade in the Heckscher-Ohlin Model

• Now, suppose that the 2 countries are under Free Trade system.

 What happens to the ”World Relative Supply Curves”?

It is in between Home and Foreign’s RS.

 𝑃𝐶 𝑃𝐶∗
,
𝑃𝐹 𝑃𝐹∗
World RS
RS* RS

𝑃𝐶 𝑃𝐶∗
=
𝑃𝐹 𝑃𝐹∗

𝑄𝐶∗ 𝑄𝐶 𝑄𝐶∗
𝑄𝐶 ,
𝑄𝐹∗ 𝑄𝐹 𝑄𝐹∗
𝑄𝐹
𝑄𝐶 + 𝑄𝐶∗
𝑄𝐹 + 𝑄𝐹∗
Equilibrium under Trade in the Heckscher-Ohlin Model
• Without Trade:

Home: RD meets RS
Foreign: RD meets RS*

• Trade:

RD line meets with World RS line.

Equilibrium under Trade in the Heckscher-Ohlin Model
𝑃𝐶 𝑃𝐶∗
,
𝑃𝐹 𝑃𝐹∗
World RS
RS* RS

𝑃𝐶∗
𝑃𝐹∗
𝑃𝐶 𝑃𝐶∗
=
𝑃𝐹 𝑃𝐹∗
𝑃𝐶
𝑃𝐹
RD

𝑄𝐶∗ 𝑄𝐶 𝑄𝐶 𝑄𝐶∗ 𝑄𝐶 + 𝑄𝐶∗

, ,
𝑄𝐹∗ 𝑄𝐹 𝑄𝐹 𝑄𝐹∗ 𝑄𝐹 + 𝑄𝐹∗
𝑄𝐶 + 𝑄𝐶∗
𝑄𝐹 + 𝑄𝐹∗
Trade in the Heckscher-Ohlin Model
• Like the Ricardian model, the Heckscher-Ohlin model predicts a
convergence of relative prices with trade.

Trade leads to a world relative price that lies between the pre-trade
prices

 With trade, the relative price of cloth rises in the relatively labor
abundant (home) country and falls in the relatively labor scarce
(foreign) country.
Trade in the Heckscher-Ohlin Model
Relative prices and the pattern of trade:
• In Home, the rise in the relative price of cloth leads to a rise in the
relative production of cloth and a fall in relative consumption of cloth.
 Home becomes an exporter of cloth and an importer of food.

• In Foreign, the fall in the relative price of cloth leads to a fall in the
relative production of cloth and a rise in relative consumption of cloth.
 Foreign becomes an importer of cloth and an exporter of food.
 Home: Before and After Trade
Before Trade:

Consumption and Production points are the same.

After Trade:

 Price of cloth becomes relatively more expensive.

 Price of food becomes relatively cheaper.

(1) Home exports Cloth and imports Food.

(2) Welfare is increased.

 Foreign: Before and After Trade
Before Trade:

Consumption and Production points are the same.

After Trade:

 Price of cloth becomes relatively cheaper.

 Price of food becomes relatively more expensive.

(1) Foreign exports food and imports cloth.

(2) Welfare is increased.

Trade in the Heckscher-Ohlin Model
• Heckscher-Ohlin theorem:
The country that is abundant in a factor exports the good whose production is intensive in
that factor.

In our 2 country-model,
Home is a labor abundant.  Home becomes an exporter of labor intensive goods.
Foreign is a capital abundant.  Foreign becomes an exporter of capital intensive goods.

 This result generalizes to a correlation:

• Countries tend to export goods whose production is intensive in factors with which
the countries are abundantly endowed.
Trade in the Heckscher-Ohlin Model
• We will study 3 important theorems.

(1) Stolper-Samuelson Theorem

(2) Rybczynski Theorem
(3) Factor Price Equalization Theorem

After learning the theorems;

we will also discuss the issue of income equality and trade,
based on the (1) and (2).
Stolper-Samuelson Theorem
• Stolper-Samuelson theorem:
Free trade enhances real income for the abundant factor and deteriorates real
income for the scarce factor.

𝒅𝒘 𝒅𝑷𝑪 𝒅𝑷𝑭 𝒅𝒓
Home: > > >
𝒘 𝑷𝑪 𝑷𝑭 𝒓

𝒅𝒘∗ 𝒅𝑷∗𝑪 𝒅𝑷∗𝑭 𝒅𝒓∗

Foreign: < < <
𝒘∗ 𝑷∗𝑪 𝑷∗𝑭 𝒓∗

 Need to understand (1) Cost-minimization and (2) Zero-profit conditions

Stolper-Samuelson Theorem
(1) Cost-minimization : Choosing the optimal mix of inputs
• Producers may choose certain amounts of factors (labor and capital) used to make
products.

 Production function 𝑄𝐶 = 𝐹 𝐿𝐶 , 𝐾𝐶 , 𝑄𝐹 = 𝐺 𝐿𝐹 , 𝐾𝐹 ,

Suppose 𝑄𝐶 = 1, 𝑄𝐹 = 1.
To produce 1 unit, producers can mix labor and capital.
 Figure 5.4 shows “Iso-quant line” for Food, as an example.
 Figure 5.4 Input Possibilities in Food Production

Due to the factor substitutability,

Iso-quant line : QF=1
1 unit of Food can be produced
with less labor and more capital,
or
with more labor and less capital.

See the shape of the iso-quant line.

Example:

1/3 2/3
𝑄𝐹 = 𝐾𝐹 𝐿𝐹 = 1 𝑐𝑎𝑙𝑜𝑟𝑖𝑒
A farmer can produce a calorie of food with
less capital if he or she uses more labor, and
vice versa.
Choosing the Mix of Inputs
MRTS = MRTS = a slope of tangent line
𝑘
Marginal Rate of Technical Substitution, along the “iso-quant line”
given a production level.
𝑑𝑘 𝑀𝑃𝐿
𝑑𝑙=+1 𝑀𝑅𝑇𝑆 ≡ − =
- If the production function is given,
𝑑𝑙 𝑀𝑃𝐾
Then MRTS can be defined as follows.
𝑑𝑘= - ???
𝑑𝑄 = 0

𝜕𝑓(𝑘,𝑙) 𝜕𝑓(𝑘,𝑙)
= × 𝑑𝑘+ × 𝑑𝑙
𝜕𝑘 𝜕𝑙
𝑸=𝟏
= 𝑀𝑃𝐾 × 𝑑𝑘 + 𝑀𝑃𝐿 × 𝑑𝑙
𝑑𝑘 𝑀𝑃𝐿 𝑙
 − =
𝑑𝑙 𝑀𝑃𝐾
Choosing the Mix of Inputs
Now, Consider Cost-Minimization, given the iso-quant line

Cost-minimization problem faced by a producer is as follows.

min 𝑐𝑜𝑠𝑡 = 𝑟𝑘 + 𝑤𝑙 𝑠𝑢𝑏𝑗𝑒𝑐𝑡 𝑡𝑜 𝑓 𝑘, 𝑙 = 1

 2 Conditions for optimal choices for the factors, k and l :

𝑀𝑃𝐿 𝑤
(i) 𝑀𝑅𝑇𝑆 ≡ =
𝑀𝑃𝐾 𝑟
(ii) 𝑓 𝑘, 𝑙 = 1
Choosing the Mix of Inputs
Unit Cost line:
𝑐𝑜𝑠𝑡𝑖 𝑤
𝑐𝑜𝑠𝑡𝑖 = 𝑟𝑘𝑖 + 𝑤𝑙𝑖 𝑘𝑖 = − 𝑙
𝑟 𝑟 𝑖

Given the w and r, the slope of the cost line is constant.

Now, to product Qi=1,

what combination of (ki, li) is minimizing “cost”?


Figure shows the cost minimizing (ki, li) satisfies:

𝑀𝑃𝐿 𝑤
(i) 𝑀𝑅𝑇𝑆 ≡ =
𝑀𝑃𝐾 𝑟
(ii) 𝑓 𝑘𝑖 , 𝑙𝑖 = 1
What if w/r increases?

𝑘𝑖′
𝑘𝑖′ B
𝑙𝑖′
A 𝑘𝑖
𝑙𝑖

𝑙𝑖′ 𝑤
𝑤′ 𝑤′
𝑟′ 𝑟 𝑟′
Choosing the Mix of Inputs
• Their choice of inputs depends on the wage, w, paid to labor and the rental rate,
r, paid when renting capital.
• As the wage w increases relative to the rental rate r, producers use less labor and
more capital in the production of both food and cloth.

𝑤
if increases, choose less l and more k.
𝑟
𝑤
if decreases, choose more l and less k.
𝑟
Choosing the Mix of Inputs
• We have two goods, cloth and food
 In each industry, the optimal mix of inputs should be determined by cost minimization

Remember:
• Assumption on sector characteristics (Heckscher-Ohlin Model)
At any given factor prices, cloth production uses more labor relative to capital than food
production uses:
𝑘𝐹 𝑘𝐶
>
𝑙𝐹 𝑙𝐶
• Production of cloth is relatively labor intensive, while production of food is
relatively capital intensive.
 Choosing the Mix of Inputs
𝑘𝐹 𝑘𝐶

𝑘𝐹 𝑘𝐶
>
𝑙𝐹 𝑙𝐶
𝑘𝐹

𝑄𝐹 = 1 𝑘𝐶

𝑙𝐹 𝑄𝐶 = 1
𝑙𝐹 𝑤 𝑙𝐶 𝑤 𝑙𝐶
𝑟 Same factor price 𝑟
 Same slope
Choosing the Mix of Inputs
𝑘𝑖
𝑙𝑖 Suppose w/r is given.

Then, labor-capital ratio is higher in

Cloth than in Food.
𝑘𝐹
𝑘𝐹 𝑘𝐶 𝑙𝐹
>
𝑙𝐹 𝑙𝐶  This figure is based on the sector
𝑘𝐶 characteristics that HO model assumes.
𝑙𝐶

𝑤
𝑤 𝑟
𝑟
 Figure 5.5 Factor Prices and Input Choices

This is a figure in our textbook.

𝑤
The Y-axis and X-axis are differently defined. 𝑟

But, it tells the same result.

I will use the previous figure.

𝑙𝐹 𝑙𝐶
𝑘𝐹 𝑘𝐶

At any given wage-rental ratio, cloth production uses a higher labor-capital

ratio; when this is the case, we say that cloth production is labor-intensive
and that food production is capital-intensive.
Mathematical Exercise: Choosing the Mix of Inputs
• Exercise: Suppose that the production functions are given as follows.
2/3 1/3 1/3 2/3
𝑄𝐹 = 𝐹 𝐾𝐹 , 𝐿𝐹 = 𝐾𝐹 𝐿𝐹 and 𝑄𝐶 = 𝐺 𝐾𝐶 , 𝐿𝐶 = 𝐾𝐶 𝐿𝐶

Then, the optimal inputs and the unit costs are calculated as follows.
Cloth:
𝑤 −1/3 𝑤 2/3
(i)𝑙𝐶 = ,𝑘𝐶 = ;
2𝑟 2𝑟
1/3 −2/3
(ii) unit-cost = 𝑟𝑘𝐶 + 𝑤𝑙𝐶 = 2 + 2 𝑤 2/3 𝑟1/3 = 𝐴 𝑤 2/3 𝑟1/3 ; and
𝑘𝐶 𝑤
(iii) =
𝑙𝐶 2𝑟

Food:
2𝑤 −2/3 2𝑤 1/3
(i)𝑙𝐹 = ,𝑘𝐹 = ;
𝑟 𝑟
1/3 −2/3
(ii) unit-cost = 𝑟𝑘𝐹 + 𝑤𝑙𝐹 = 2 + 2 𝑤 1/3 𝑟 2/3 = 𝐴 𝑤 1/3 𝑟 2/3 ; and
𝑘𝐹 2𝑤
(iii) =
𝑙𝐹 𝑟
(2) Zero-profit
• Under a perfect competition, profit should be 0.
 For 1 unit of sales, Price = unit cost

𝑃𝐹 = 𝑟𝑘𝐹 + 𝑤𝑙𝐹 and 𝑃𝐶 = 𝑟𝑘𝐶 + 𝑤𝑙𝐶

Here, the unit costs are those we found in the cost-minimization.

In our exercise, we can have zero profit conditions as follows:

𝑃𝐹 = 𝐴 𝑤 1/3 𝑟 2/3 and 𝑃𝐶 = 𝐴 𝑤 2/3 𝑟1/3
 𝑃𝐹 = 𝑟𝑘𝐹 + 𝑤𝑙𝐹 = 𝐴 𝑤 1/3 𝑟 2/3

𝑃𝐶 = 𝑟𝑘𝐶 + 𝑤𝑙𝐶 = 𝐴 𝑤 2/3 𝑟1/3

When the 2 zero-profit conditions meet,

we can find out the wage (w) and rental
price (r) for both industries.

[2 zero profit conditions]

 Zero profit conditions
Total differentiations

𝑘𝐹 𝑑𝑟 + 𝑙𝐹 𝑑𝑤 = 0 𝑎𝑛𝑑 𝑘𝐶 𝑑𝑟 + 𝑙𝐶 𝑑𝑤=0
𝑑𝑟
− Industry characteristics assumed
𝑑𝑤 𝐹
𝑑𝑟 𝑙𝐹 𝑙𝐶 𝑑𝑟
B − = < = −
𝑑𝑤 𝐹
𝑘𝐹 𝑘𝐶 𝑑𝑤 𝐶

𝑑𝑟
−
𝑑𝑤 𝐶
 See the point B.

From 𝑃𝐹 = 𝑟𝑘𝐹 + 𝑤𝑙𝐹 , take the total differentiation with respect to, PF, w, and r.

𝜕𝑘𝐹 𝜕𝑙𝐹 𝜕𝑘𝐹 𝜕𝑙𝐹

𝑑𝑃𝐹 = 0 = 𝑘𝐹 + 𝑟 +𝑤 𝑑𝑟 + 𝑙𝐹 + 𝑟 +𝑤 𝑑𝑤 = 𝑘𝐹 𝑑𝑟 + 𝑙𝐹 𝑑𝑤
𝜕𝑟 𝜕𝑟 𝜕𝑤 𝜕𝑤

From 𝑃𝐶 = 𝑟𝑘𝐶 + 𝑤𝑙𝐶 , take the total differentiation with respect to, PC, w, and r.

𝜕𝑘𝐶 𝜕𝑙𝐶 𝜕𝑘𝐶 𝜕𝑙𝐶

𝑑𝑃𝐶 = 0 = 𝑘𝐶 + 𝑟 +𝑤 𝑑𝑟 + 𝑙𝐶 + 𝑟 +𝑤 𝑑𝑤 = 𝑘𝐶 𝑑𝑟 + 𝑙𝐶 𝑑𝑤
𝜕𝑟 𝜕𝑟 𝜕𝑤 𝜕𝑤

Note: 𝑑𝑃𝐹 = 0 and 𝑑𝑃𝐶 = 0 (This is because there is no change in prices.)

𝜕𝑘𝐹 𝜕𝑙𝐹 𝜕𝑘𝐹 𝜕𝑙 𝜕𝑘𝐶 𝜕𝑙𝐶 𝜕𝑘𝐶 𝜕𝑙

𝑟 +𝑤 =0; 𝑟 + 𝑤 𝜕𝑤𝐹 =0; 𝑟 +𝑤 =0; and 𝑟 + 𝑤 𝜕𝑤𝐶 =0
𝜕𝑟 𝜕𝑟 𝜕𝑤 𝜕𝑟 𝜕𝑟 𝜕𝑤

𝑑𝑘 𝑤
 This is because of the cost minimization: 𝑀𝑅𝑇𝑆 ≡ − 𝑑𝑙 𝑖 = 𝑟
, for i=C, F
𝑖
Factor Prices and Goods Prices
Summary:
• In competitive markets, the price of a good should equal the unit cost of the production, which
depends on the factor prices.

• How changes in the wage and rent affect the cost of producing a good depends on the mix of
factors used.

 An increase in the rental price of capital should affect the price of food more than the price
of cloth since food is the capital intensive industry.

 An increase in the wage rate for labor should affect the price of cloth more than the price of
food since cloth is the labor intensive industry.

w
• Changes in are tied to changes in PC .
r PW
Figure 5.6 Factor Prices and Goods Prices
From our mathematical example:
w
As increases, 𝑃𝐶 𝑤 1Τ3
r 𝑃𝐹
=
𝑟
PC
. should increases as well.
PW

Alternatively,
PC
As . increases,
PW
w
should increase as well.
r
Because cloth production is labor-intensive while food
production is capital-intensive,
the higher the relative cost of labor, the higher must be the
relative price of the labor-intensive good.
Stolper-Samuelson theorem:
Now we are ready to understand the Stolper-Samuelson theorem:

Stolper-Samuelson theorem:
Free trade enhances real income for the abundant factor and deteriorates real
income for the scarce factor.

𝒅𝒘 𝒅𝑷𝑪 𝒅𝑷𝑭 𝒅𝒓
Home: > > >
𝒘 𝑷𝑪 𝑷𝑭 𝒓

𝒅𝒘∗ 𝒅𝑷∗𝑪 𝒅𝑷∗𝑭 𝒅𝒓∗

Foreign: < < <
𝒘∗ 𝑷∗𝑪 𝑷∗𝑭 𝒓∗
Use the zero-profit conditions and take total differentiation with respect to Pi, w and r as follows, for i=F, C.

𝑑𝑃𝑖 = 𝑘𝑖 𝑑𝑟 + 𝑙𝑖 𝑑𝑤 (see page 67)

Now we divide both sides by prices of goods or unit cost: 𝑃𝑖 = 𝐶𝑖 (= 𝑟𝑘𝑖 + 𝑤𝑙𝑖 )

𝑑𝑃𝑖 𝑘𝑖 𝑑𝑟 𝑙𝑖 𝑑𝑤 𝑘𝑖 𝑑𝑟 𝑙𝑖 𝑑𝑤 𝑟𝑘𝑖 𝑑𝑟 𝑤𝑙𝑖 𝑑𝑤

 = + = + = +
𝑃𝑖 𝑃𝑖 𝑃𝑖 𝐶𝑖 𝐶𝑖 𝐶𝑖 𝑟 𝐶𝑖 𝑤

𝑟𝑘𝑖 𝑤𝑙𝑖 𝑟𝑘𝑖

Then, define: 𝜃𝑖𝐾 ≡ , 𝜃𝑖𝐿 ≡ =1− = 1 − 𝜃𝑖𝐾 and 𝐶𝑖 = 𝑟𝑘𝑖 + 𝑤𝑙𝑖
𝐶𝑖 𝐶𝑖 𝐶𝑖

𝑑𝑃𝐹 𝑑𝑟 𝑑𝑤 𝑑𝑋
= 𝜃𝐹𝐾 + 𝜃𝐹𝐿 Note: About
𝑃𝐹 𝑟 𝑤 𝑋

𝑑𝑃𝐶 𝑑𝑟 𝑑𝑤 𝑋2 −𝑋1
= 𝜃𝐶𝐾 + 𝜃𝐶𝐿 
𝑃𝐶 𝑟 𝑤 𝑋1

 If multiply with 100,

then it is a percentage change of X1 to X2
(%Δ)
𝑑𝑃𝐹 𝑑𝑟 𝑑𝑤
= 𝜃𝐹𝐾 + 𝜃𝐹𝐿 Result in Stolper-Samuelson for Home 𝒅𝒘 𝒅𝑷𝑪 𝒅𝑷𝑭 𝒅𝒓
𝑃𝐹 𝑟 𝑤
𝑑𝑃𝐶 𝑑𝑟 𝑑𝑤 > >𝟎> >
𝒘 𝑷𝑪 𝑷𝑭 𝒓
= 𝜃𝐶𝐾 + 𝜃𝐶𝐿
𝑃𝐶 𝑟 𝑤

Why?
(1) 0 < 𝜃𝐹𝐾 < 1; the percentage change of a product price is
0 < 𝜃𝐹𝐿 < 1; “weighted average” of percentage change of two factor prices (w, r).
0 < 𝜃𝐶𝐾 < 1;  Percentage change of a price must be in between percentage
0 < 𝜃𝐶𝐿 < 1; changes in the two factor prices.

(2) Free trade system makes the price of Cloth increased and the price of Food decreased in Home.
𝑑𝑃 𝑑𝑃
That is, 𝑃 𝐶 > 0 > 𝑃 𝐹 as a result of free trade in Home.
𝐶 𝐹

(3) Consider the 2 zero-profit conditions.

Then, an increase in the product price ratio (due to the free trade) generates
an increase in the relative factor prices.
𝑑𝑤 𝑑𝑟
That is, >0> as a result of free trade in Home.
𝑤 𝑟
 Home Country case:

+ -
PC increases and PF decreases in 𝑑𝑃𝐶 𝑑𝑃𝐹
Home due to Free Trade >0>
𝑃𝐶 𝑃𝐹

+ -
w increases and r decreases in Home 𝑑𝑤 𝑑𝑟
as a result of free trade >0>
𝑤 𝑟
Stolper-Samuelson theorem:
• How about Foreign?  Mirror Image!!
- - + +
𝒅𝒘∗ 𝒅𝑷∗𝑪 𝒅𝑷∗𝑭 𝒅𝒓∗
Foreign: < <𝟎< <
𝒘∗ 𝑷∗𝑪 𝑷∗𝑭 𝒓∗

𝒅𝒘 𝒅𝑷𝑪 𝒅𝑷𝑭 𝒅𝒓
Home: > >𝟎> >
𝒘 𝑷𝑪 𝑷𝑭 𝒓
+ + - -
• Stolper-Samuelson theorem:
Free trade enhances real income for the abundant factor and deteriorates real
income for the scarce factor.
Stolper-Samuelson theorem: Mathematical example
• In our example: We prove the theorem for Home.
𝑑𝑤 𝑑𝑟
we can solve the two equations with respect to and for Home country as follows.
𝑤 𝑟

𝑑𝑃𝐹 2 𝑑𝑟 1 𝑑𝑤 𝑑𝑃𝐶 1 𝑑𝑟 2 𝑑𝑤 𝑑𝑤 𝑑𝑟
• = + and = +  solve the system of equations for and
𝑃𝐹 3 𝑟 3 𝑤 𝑃𝐶 3 𝑟 3 𝑤 𝑤 𝑟

𝑑𝑤 𝑑𝑃𝐶 𝑑𝑃𝐹 𝑑𝑟 𝑑𝑃𝐹 𝑑𝑃𝐶

 =2 − and =2 −
𝑤 𝑃𝐶 𝑃𝐹 𝑟 𝑃𝐹 𝑃𝐶

𝑑𝑤 𝑑𝑃𝐶 𝑑𝑃 𝑑𝑃𝐶 𝑑𝑃𝐶 𝑑𝑃 𝑑𝑃𝐶

So, =2 − 𝐹 > + − 𝐹 > > 0 and
𝑤 𝑃𝐶 𝑃𝐹 𝑃𝐶 𝑃𝐶 𝑃𝐹 𝑃𝐶
𝑑𝑟 𝑑𝑃 𝑑𝑃 𝑑𝑃𝐹 𝑑𝑃𝐹 𝑑𝑃 𝑑𝑃𝐹
= 2 𝐹− 𝐶 = + − 𝐶 < <0
𝑟 𝑃𝐹 𝑃𝐶 𝑃𝐹 𝑃𝐹 𝑃𝐶 𝑃𝐹

• We can repeat the same process for Foreign to prove the opposite inequality result.
Rybczynski theorem: Resources and Output
• How do levels of output change when the economy’s resources change?

• Rybczynski theorem:

If you hold output prices constant as the amount of a factor of

production increases, then the supply of the good that uses this factor
intensively increases and the supply of the other good decreases.
 Rybczynski theorem
As an example:
L endowment
Suppose that an economy’s labor force (L) grows, which implies
Is increased. L
that its endowment ratio of labor to capital increases.
K
 Figure 5. 8: Expansion of production possibilities is biased toward cloth.

Why?
(1) At a given relative price of cloth, the ratio of labor to capital used in both
sectors remains constant. (by the choice of “cost-minimization)
(2) To employ the additional workers, the economy expands production of the
relatively labor-intensive good cloth and contracts production of the relatively
capital-intensive good food.
Figure 5.8 Resources and Production Possibilities

Small expansion
Same price ratio given.

Rybczynski line

Large expansion
An increase in the supply of labor shifts the economy’s production possibility frontier outward
disproportionately in the direction of cloth production.
At an unchanged relative price of cloth, food production declines.
Rybczynski theorem

When L increases, find out the Rybczynski line:

The followings are the endowment equations for K and L in Home:

𝐾 = 𝐾𝐹 +𝐾𝐶 = 𝑘𝐹 𝑄𝐹 + 𝑘𝐶 𝑄𝐶
𝐿 = 𝐿𝐹 +𝐿𝐶 = 𝑙𝐹 𝑄𝐹 + 𝑙𝐶 𝑄𝐶

𝑑𝐾 = 0 𝑎𝑛𝑑 𝑑𝐿 > 0  𝑑𝐾 = 0 = 𝑘𝐹 𝑑𝑄𝐹 + 𝑘𝐶 𝑑𝑄𝐶

𝑑𝑄 𝑘
So, the Rybczynki line = 𝑑𝑄𝐹 = − 𝑘𝐶 < 0
𝐶 𝐹

Try: Can you find out the Rybczynski line when K increases in Home?
Rybczynski theorem

Alternative way to explain the theorem:

Endowment equations for K and L in Home:

𝐾 = 𝐾𝐹 +𝐾𝐶 = 𝑘𝐹 𝑄𝐹 + 𝑘𝐶 𝑄𝐶

𝐿 = 𝐿𝐹 +𝐿𝐶 = 𝑙𝐹 𝑄𝐹 + 𝑙𝐶 𝑄𝐶

1∗𝑘𝐹 𝑘𝐹 1∗𝑘𝐶 𝑘𝐶
For 𝑄𝐹 =1, Home uses = . And For 𝑄𝐶 =1, Home uses = .
1∗𝑙𝐹 𝑙𝐹 1∗𝑙𝐶 𝑙𝐶

𝑘𝐹 𝑄𝐹 𝑘𝐹 𝑘𝐶 𝑄𝐶 𝑘𝐶
For 𝑄𝐹 > 0, Home uses = . And For 𝑄𝐶 > 0, Home uses = .
𝑙𝐹 𝑄𝐹 𝑙𝐹 𝑙𝐶 𝑄𝐶 𝑙𝐶

 See the Figure in the next page:

 𝑘𝐹 𝑘𝐶
Given > ,
𝑙𝐹 𝑙𝐶

the allocation of K and L to Cloth and Food

should be equal to total K and L.
𝐾 = 𝐾𝐹 +𝐾𝐶
= 𝑘𝐹 𝑄𝐹 + 𝑘𝐶 𝑄𝐶
(K, L) “Parallelogram”
K

𝐿 = 𝐿𝐹 +𝐿𝐶
= 𝑙𝐹 𝑄𝐹 + 𝑙𝐶 𝑄𝐶
 Rybczynski theorem
• To understand the theorem, let us increase L. 𝑄𝐹 > 𝑄𝐹′ and 𝑄𝐶 < 𝑄𝐶′

Production of labor intensive

good (cloth) increases, while
production of capital intensive
good (food) decreases.
 Rybczynski theorem
• To understand the theorem, let us increase K. 𝑄𝐹 < 𝑄𝐹′ and 𝑄𝐶 > 𝑄𝐶′

Production of labor intensive

good (cloth) decreases, while
production of capital intensive
good (food) increases.
Factor Price Equalization
• Free trade makes (1) the relative factor prices equalized between Home and Foreign.
Furthermore, free trade makes (2) the absolute level of factor prices equalized
between them as well.

𝑤 𝑤∗
(1) = ; and (2) 𝑤 = 𝑤 ∗ , 𝑟 = 𝑟 ∗ .
𝑟 𝑟∗

See the Figure:

Upper panel: Combine the 2 zero profit conditions .

Lower panel: Use the 2 conditions for the cost minimizations

and equations for factor prices determinations
 𝑃𝐶 𝑤 1Τ3
=
𝑃𝐹 𝑟
Foreign’s prices under Autarky

Home and Foreign’s prices

under Free Trade

Home’s prices under Autarky

(1) When the price ratio becomes the same

in both countries under Free Trade,
The factor price ratio(w/r) also becomes the same.

 from our example:

𝑃𝐶 𝑤 1Τ3
=
𝑃𝐹 𝑟
 𝑃𝐶 𝑤 1Τ3
=
𝑃𝐹 𝑟
Foreign’s prices under Autarky

Home and Foreign’s prices

under Free Trade

Home’s prices under Autarky

(2) When factor price ratio becomes the same,

𝑘𝐹
becomes also the same in both countries, and
𝑙𝐹
𝑘𝐶
becomes also the same in both countries.
𝑙𝐶

 Then, w and r become the same in both countries.

𝑤 = 𝑃𝐹 𝑀𝑃𝐿𝐹 = 𝑃𝐶 𝑀𝑃𝐿𝐶

𝑟 = 𝑃𝐹 𝑀𝑃𝐾𝐹 = 𝑃𝐶 𝑀𝑃𝐾𝐶
𝑘𝑖
Note: MPL and MPK are the function of 𝑙𝑖
In our mathematical example:

𝑘
(1) the marginal product of labor and capitals are the function of 𝑙 due to the constant returns to scale as
follows.

2 𝑘𝐹 2/3 2 𝑘𝐹 −1/3 2 𝑘𝐶 1/3 1 𝑘𝐶 −2/3

𝑀𝑃𝐿𝐹 = ; 𝑀𝑃𝐾𝐹 = ; 𝑀𝑃𝐿𝐶 = ; 𝑀𝑃𝐾𝐹 =
3 𝑙𝐹 3 𝑙𝐹 3 𝑙𝐶 3 𝑙𝐶

𝑘𝐶 𝑘𝐹
So, When 𝑙𝐶
is the same in both countries, and 𝑙𝐹
is also the same in both countries,
The MPL and MPK are also the same in both countries.

(2) Since the prices of cloth and food are the same in both countries,

 so, from (1) and (2),

the absolute factor prices becomes the same in both countries as well.

𝑤 = 𝑤∗

𝑟 = 𝑟∗
Empirical Evidence
(1) Stolper-Samuelson Theorem
 Did trade actually cause income inequality within a country?

(2) Factor Price Equalization

 Did trade actually make factor prices equalized among countries?

(3) Heckscher-Ohlin Theorem

 Can Factor abundance explain the patterns of trade?

(4) “Missing” Trade ?!!

(1) Discussion on “Trade and the Distribution of Income”
According to the Stolper-Samuelson Theorem:

Changes in relative prices can affect the earnings of labor and capital.

Home country: as a result of Free Trade,

(1) A rise in the price of cloth raises the purchasing power of wage rate in terms of
both goods while lowering the purchasing power of rental price in terms of both
goods.

Foreign country: as a result of Free Trade,

(2) A rise in the price of food raises the purchasing power of rental price in terms of
both goods while lowering the purchasing power of wage rate in terms of both goods.
Trade and the Distribution of Income
• Thus, theoretically, international trade can affect the distribution of
income, even in the long run:

 Owners of a country’s abundant factors gain from trade, but

owners of a country’s scarce factors lose.

• Factors of production that are used intensively by the import-

competing industry are hurt by the opening of trade—regardless
of the industry in which they are employed.
Trade and the Distribution of Income
Consider US as an example:
• Compared with the rest of the world, the United States is
abundantly endowed with highly skilled labor while low-skilled labor
is correspondingly scarce.

 International trade has the potential to make low-skilled

workers in the United States worse off—not just temporarily, but
on a sustained basis.
Trade and the Distribution of Income
• However,
changes in income distribution occur with every economic change, not only
international trade.

 (1) Changes in technology, (2) changes in consumer preferences, (3) exhaustion of

resources and (4) discovery of new ones all affect income distribution.

 Economists put most of the blame on technological change and the resulting
premium paid on education as the major cause of increasing income inequality in
the United States.

Regarding Trade:
• It would be better to compensate the losers from trade (or any economic change) than
prohibit trade.
• The economy as a whole does benefit from trade.
North-South Trade and Income Inequality

• Over the last 40 years, countries such as South Korea, Mexico, and China
have exported to the United States goods intensive in unskilled labor
(e.g., clothing, shoes, toys, assembled goods).

• At the same time, income inequality has increased in the United States,
as wages of unskilled workers have grown slowly compared to those of
skilled workers.

• Did the former trend cause the latter trend?

North-South Trade and Income Inequality

• The Heckscher-Ohlin model predicts that owners of relatively abundant

factors will gain from trade and owners of relatively scarce factors will
lose from trade.
 Little evidence supporting this prediction exists.
 Why?

1. According to the model, a change in the distribution of income

occurs through changes in output prices, but there is no evidence of
a change in the prices of skill-intensive goods relative to prices of
unskilled-intensive goods.
North-South Trade and Income Inequality

2. According to the model, wages of unskilled workers should increase

in unskilled labor abundant countries relative to wages of skilled
labor, but in some cases the reverse has occurred:

Examples: Mexico
• Wages of skilled labor have increased more rapidly in Mexico
than wages of unskilled labor.
• But compared to the United States and Canada, Mexico is
supposed to be abundant in unskilled workers.
North-South Trade and Income Inequality

3. Even if the model were exactly correct, trade is a small fraction of the
U.S. economy, so its effects on U.S. product prices and factor prices
(wages of skilled and unskilled workers) should be small.

In sum,
• The majority view of trade economists is that the villain is not trade
but rather new production technologies that put a greater emphasis on
worker skills (such as the widespread introduction of computers and
other advanced technologies in the workplace).

 “Skill-Biased Technological Change” and Income Inequality

 Figure 5.11 Evolution of U.S. Non-Production–Production
Employment Ratios in Four Groups of Sectors

Sectors are grouped based on their skill intensity. The non-production–production employment ratio has
increased over time in all four sector groups.
Source: NBER-CES Manufacturing Productivity Database.
Capital-Skill Complementarity
• Next, Figure 5.12 shows that the trend toward lower labor income share
(and higher capital shares) is a worldwide phenomenon.
 Experienced in labor-abundant countries (including China, India, and
Mexico) to the same extent as it has been for capital-abundant countries
such as the United States.

• The evidence supports an explanation based on technological changes

within sectors—not increased import competition.
Figure 5.12 U.S. and Average World Corporate Labor Share

Unweighted world average for all 59 countries with available data.

Source: Loukas Karabarbounis and Brent Neiman, “The Global Decline of the Labor
Share,” The Quarterly Journal of Economics 129.1 (2014), pp. 61–103.
(2) Factor Price Equalization
• Unlike the Ricardian model, the Heckscher-Ohlin model predicts that
factor prices will be equalized among countries that trade.

Logics summarized:
(1) Free trade equalizes relative output prices.
(2) Due to the connection between output prices and factor prices, factor
prices (in level and in ratio both) are also equalized.
(3) why? Trade increases the demand of goods produced by relatively
abundant factors, indirectly increasing the demand of these factors, raising
the prices of the relatively abundant factors.
Factor Price Equalization
• However, in the real world, we observe that factor prices are actually not equal
across countries.
 See table 5.1

What is the problem?

(1) The model assumes that trading countries produce the same goods, but
countries may produce different goods if their factor ratios radically differ.

(2) The model also assumes that trading countries have the same technology, but
different technologies could affect the productivities of factors and therefore the
wages/rates paid to these factors.
Table 5.1 Comparative International Wage Rates
Country Hourly Compensation of Manufacturing Workers 2016 (United States = 100)
Switzerland 154.64
Germany 110.63
United States 100.00
United Kingdom 72.79
Japan 67.80
South Korea 58.87
Argentina 42.97
Greece 40.22
Portugal 28.08
Czech Republic 27.43
Poland 21.83
Brazil 20.45
Turkey 15.61
Mexico 10.02
Philippines 5.27

Source: The Conference Board, International Labor Comparisons.

Factor Price Equalization
(3) The model also ignores trade barriers and transportation costs, which
may prevent output prices and thus factor prices from equalizing.

(4) The model predicts outcomes for the long run, but after an economy
liberalizes trade, factors of production may not quickly move to the industries
that intensively use abundant factors.
 In the short run, the productivity of factors will be determined by their
use in their current industry, so that their wage/rental rate may vary
across countries.
(3) Empirical Evidence on the Heckscher-Ohlin Model
• Tests on U.S. data
• Leontief found that U.S. exports were less capital-intensive than
U.S. imports, even though the United States is the most capital-
abundant country in the world: Leontief paradox.

• Tests on global data

• Bowen, Leamer, and Sveikauskas tested the Heckscher-Ohlin model
on data from 27 countries and confirmed the Leontief paradox on
an international level.
Table 5.2 Factor Content of U.S. Exports and Imports for 1962

blank

Imports Exports
Capital per million dollars $2,132,000 $1,876,000
Labor (person-years) per million dollars 119 131
Capital-labor ratio (dollars per worker) $17,916 $14,321
Average years of education per worker 9.9 10.1
Proportion of engineers and scientists in work force 0.0189 0.0255

Source: Robert Baldwin, “Determinants of the Commodity Structure of U.S. Trade,” American
Economic Review 61 (March 1971), pp. 126-145.
Empirical Evidence on the Heckscher-Ohlin Model
• Contrast the exports of labor-abundant, skill-scarce nations in the
developing world with the exports of skill-abundant, labor-scarce (rich)
nations.

Figure 5.13: Bangladesh, Cambodia, Haiti VS France, Germany, UK

 The exports of the three developing countries to the United States are
concentrated in sectors with the lowest skill intensity.

 The exports of the three skill abundant countries to the United States are
concentrated in sectors with higher skill intensity.
Figure 5.13 Export Patterns for a Few Developed and
Developing Countries, 2008–2012

Source: NBER-CES U.S. Manufacturing Productivity Database, U.S. Census Bureau, and Peter K.
Schott, “The Relative Sophistication of Chinese Exports,” Economic Policy (2008), pp. 5–49.
Empirical Evidence on the Heckscher-Ohlin Model
China’s export over time
• Or compare how exports change when a country such as China grows and becomes
relatively more skill-abundant:

Figure 5.14: China

 The concentration of exports in high-skill sectors steadily increases over time.

 In the most recent years, the greatest share of exports is transacted in the highest
skill-intensity sectors, whereas exports were concentrated in the lowest skill-
intensity sectors in the earlier years.
Figure 5.14 Changing Pattern of Chinese Exports over Time

Source: NBER-CES U.S. Manufacturing Productivity Database, U.S. Census Bureau, and Peter K.
Schott, “The Relative Sophistication of Chinese Exports,” Economic Policy (2008), pp. 5–49.
(4) Missing Trade
Now, Back to the Factor Price Equalization:

The model predicts that until factor prices are equalized between countries, factors
(workers and capital owners) will keep increasing and producing export products.
 The theoretically predicted volume of trade is the maximized one when the factor
prices are equalized finally.

• But, in a real world because factor prices are not actually equalized across countries,
the theoretically predicted volume of trade is much larger than actually occurs.

 A result of “missing trade” discovered by Daniel Trefler.

(4) Missing Trade
• The reason for this “missing trade” appears to be the assumption of identical
technology among countries.

 In fact, technology levels of countries are quite diverse.

Table 5.3 Estimated Technological Efficiency, 1983
blank

Country
Bangladesh 0.03
Thailand 0.17
Hong Kong 0.40
Japan 0.70
West Germany 0.78
United States 1

Source: Daniel Trefler, “The Case of the Missing Trade and Other mysteries,” American
Economic Review (December 1995), pp. 1029–1046.
Empirical Evidence on the Heckscher-Ohlin Model
• An important study by Donald Davis and David Weinstein showed that
if relax the assumption of common technologies, along with assumptions
underlying factor price equalization (countries produce the same goods
and costless trade equalizes prices of goods):
 then the predictions for the direction and volume of the factor content
of trade line-up well with empirical evidence and ultimately generate a
good fit.

• Difficulty finding support for the predictions of the “pure” Heckscher-Ohlin

model can be blamed on some of the assumptions made.
Table 5.4 A Better Empirical Fit for the Factor Content of Trade

Assumptions Assumptions Assumptions Assumptions

Dropped Dropped Dropped Dropped
blank None Drop (1) Drop (1)-(2) Drop (1)-(3)
Predictive Success
(sign test for export:
observed vs predicted) 0.32 0.50 0.86 0.91
Missing Trade
(observed/predicted) 0.0005 0.008 0.19 0.69

Assumptions: (1) common technologies across countries; (2) countries produce the same set
of goods; and (3) costless trade equalizes goods prices.
Source: Donald R. Davis and David Weinstein, “An Account of Global Factor Trade,” American Economic
Review (2001), pp. 1423–1453.