Lecture 3: Two-factor economy:

The Heckscher-Ohlin model

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***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 Content
1. Model of a Two-factor Economy
 Prices & production
 Choosing mix of inputs
 Factor prices & Good prices
 Resources & Output
2. Effects of International trade between Two-factor Economies
 Relative prices & the pattern of trade
 Trade and the distribution of income
 Factor-price equalization

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 1. Two-factor Economy
 In the real world, while trade is partly explained by differences in labor
productivity, it also reflects differences in countries’ resources.
 The Heckscher-Ohlin theory:
 Emphasizes resource differences as the only source of trade
 Shows that comparative advantage is influenced by:
 Relative factor abundance (refers to countries)
 Relative factor intensity (refers to goods)
 Is also referred to as the factor-proportions theory (2 by 2 by 2)

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 1. Two-factor Economy
  
 Assumptions of the Model
 An economy can produce two goods, cloth (C) and food (F)
 The production of these goods requires two inputs that are in limited
supply; labor (L) and land or capital (K).
 Production of food is land-intensive and production of cloth is labor-
intensive in both countries.
 Perfect competition prevails in all markets.
Amount produced

K & L are fixed supply of capital & labor in the economy

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 1.1 Prices & production

- Assume that the immobile factors that were specific to each sector (capital in cloth, land
in food) are now mobile in the long run. In the long run, both capital and labor can move
across sectors, thus equalizing their returns (rental rate and wage) in both sectors.

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 Production possibility frontier
No possibility of substituting labor for capital or vice versa
 To produce :
 Constraints:
 

 To produce :
 

Assume K= 3,000 units of machine – hours, L= 2,000 units of work – hours.

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 Production possibility frontier
 2 ∗𝑄 +3 ∗𝑄 𝐹 ≤ 3,000(capital )
𝐶
  (labor)

• Production possibility frontier is the

kinked red line
• The opportunity cost of cloth is is
higher when more units of cloth are
being produced (from 2/3 to 2 when
moving from left to right).

No possibility of substituting labor for capital or vice versa

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 Production possibility frontier
Allow the possibility of substituting
labor for capital or vice versa
 Kink is removed. Opportunity cost of cloth
increases when more cloth is produced.

 Where to produce? Depend on prices

maximize value of production

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 Production possibility frontier
  Insovaluelines have constant
output value, slope =
 Produce at point Q, the slope of
the PPF =
 The opportunity cost of cloth is
equal to the relative price of cloth .

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 1.2 Choosing mix of inputs
  Producer faces trade-offs of input mix
 The input choice will depend on the ratio
(factor prices)
wage rate
rental cost

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1.2 Choosing mix of inputs
  Factor Intensity:
At any given factor prices, production of cloth will
always use more labor relative to capital (L/K)
than will production of food.

 Example: If food production uses 80 workers and

200 land acres, while cloth production uses 20
workers and 20 acres, then food production is
land-intensive and cloth production is labor-
intensive.

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 1.2 Choosing mix of inputs
 Substitution effect in producer’s factor demand:
 As wage rises relative to rental, producer
substitutes capital for labor in their production
decisions.

 𝑤  𝐿
𝑟 𝐾

CC and FF are relative factor demand curves

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 1.3 Factor Prices and Goods Prices
 Stolper-Samuelson Theorem
(effect):
 If the relative price of a good
increases, holding factor supplies
constant, then the nominal and real
return (in terms of both goods) to the
factor used intensively in the
production of that good increases,
while the nominal and real return (in
terms of both goods) to the other
factor decreases.
 The reverse is also true.
Cloth is labor-intensive
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1.3 Factor Prices and Goods Prices
An increase in the price of cloth relative to
that of food, PC/PF ,will:

• Raise the income of workers relative to

that of landowners, w/r.
• Raise the ratio of land to labor, K/L (or
reduces L/K), in both cloth and food
production and thus raise the marginal
product of labor in terms of both goods.
• Raise the purchasing power of workers
and lower the purchasing power of
landowners, by raising real wages and
lowering real rents in terms of both goods.

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 1.4 Resources and Output

 Given relative price of cloth unchanged (slope –

Pc/PF), increase in labor force (L/K increases)
The production possibility frontier shifts outward
much more toward cloth production direction than
food (disproportionally)  biased expansion of
production possibilities  the economy produces
more cloth and less food.
 Rybczynski Theorem (effect): If a factor of
production (T or L) increases, then the supply of
the good that uses this factor intensively increases
and the supply of the other good decreases for any
given commodity prices.

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 2. Effects of International Trade Between Two-Factor Economies

 Assumptions of the Heckscher-Ohlin model:

• There are two countries (Home and Foreign) that have:
• Same tastes
• Same technology
• Different resources
• Home has a higher ratio of labor to land than Foreign does
(Home is labor-abundant, Foreign is capital-abundant)
 Each country has the same production structure of a two-factor economy.

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 2.1 Relative Prices and the Pattern of Trade
 Factor Abundance
 Home country is labor-abundant compared to Foreign country (and Foreign is land-
abundant compared to Home) if and only if the ratio of the total amount of labor to
the total amount of land available in Home is greater than that in Foreign:

L/K > L*/ K*

 Example: if America has 80 million workers and 200 million acres, while Britain has 20
million workers and 20 million acres, then Britain is labor-abundant and America is
land-abundant.
 In this case, the scarce factor in Home is land and in Foreign is labor.

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2.1 Relative Prices and the Pattern of Trade
  Home has larger relative supply of cloth (higher
thus Home supply curve (RS) lies further to the
right than Foreign’s (RS*)
 RD: relative demand curve
 No international trade: Home equilibrium is
point 1, Foreign’s is point 3 
 With trade, relative prices converge to point 2.

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 2.1 Relative Prices and the Pattern of Trade
 When Home and Foreign trade with each other, their relative prices converge. The
relative price of cloth rises in Home and declines in Foreign.
 In Home, the rise in the relative price of cloth leads to a rise in the production of cloth and a
decline in relative consumption, so Home becomes an exporter of cloth and an importer of
food.
 Conversely, the decline in the relative price of cloth in Foreign leads it to become an importer of
cloth and an exporter of food.
 Heckscher-Ohlin Theorem:
 A country will export that commodity which uses intensively its abundant factor and
import that commodity which uses intensively its scarce factor.

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 2.2 Trade and the Distribution of Income
 Changes in relative prices have strong effects on the relative earnings of labor
and land in both countries:
• In Home, where the relative price of cloth rises:
Laborers are made better off and landowners (capital owners) are made worse off.
• In Foreign, where the relative price of cloth falls, the opposite happens:
Laborers are made worse off and landowners are made better off.
 Owners of a country’s abundant factors gain from trade, but owners of a
country’s scarce factors lose.

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 2.3 Factor Price Equalization

 In the absence of trade: labor would earn less in

Home than in Foreign, and land would earn more.
 Factor-Price Equalization Theorem:
 International trade leads to complete
equalization in factor prices of homogeneous
factors across countries.
It implies that international trade is a substitute
for the international mobility of factors. Home
exports its labor (by exporting cloths), Foreign
exports its capital.

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 2.3 Factor Price Equalization
 Has international trade equalized the returns to homogeneous factors in
different countries in the real world?
 Even casual observation clearly indicates that it has not.
 Example: Wages are much higher for doctors, engineers, technicians, mechanics and laborers
in the United States and Germany than in Korea and Mexico.
 Under these circumstances, it is more realistic to say that international trade has
reduced, rather than completely eliminated, the international difference in the
returns to homogeneous factors.

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Comparative International Wage Rates (United States = 100)

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 2.3 Factor Price Equalization

 Three assumptions crucial to the prediction of factor price equalization are

in reality untrue:
 Both countries produce both goods
 Both countries have the same technologies in production
 Both countries have the same prices of goods due to trade

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU