Factor endowments and the heckscher ohlin theory (chapter 5)

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2. PRESENTED TO:
AYESHA AKHTER
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DEPARTMENT OF FINANCE
JAGANNATH UNIVERSITY
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3. GROUP: 4
SL
NO.
ROLL NAME
1. B-120203032 RAJIB HUSSAIN
2. B-120203034 ASIBUL ISLAM MILU
3. B-120203043 TAJRIMA SULTANA SRISTI
4. B-120203045 MOHAMMADWASHIM
5. B-120203047 RASELAHAMED
6. B-120203055 SUJAN BHUIYAN
7. B-120203071 GAZI RAFSAN SHAHAB
8. B-120203137 AFRIN KHAN
9. B-110203091 EHSUN HOQUE

4. CHAPTER 5
FACTOR ENDOWMENTS AND THE HECKSCHER-OHLIN
THEORY

5. RASEL AHAMED
ID: B-120203047

6. In this chapter:
Introduction
Assumptions of the Theory
Factor Intensity, Factor Abundance, and the Shape of the
Production Frontier
Factor Endowments and the Heckscher-Ohlin Theory
Factor-Price Equalization and Income Distribution
Empirical Tests of the Heckscher-Ohlin Model

7. Introduction
In this Chapter, we extend our trade model in order to identify one of the
most important determinants of the difference in the pretrade-relative
commodity prices and the comparative advantage among nations. This also
allows us to examine the effect that international trade has on the relative
price and income of the various factors of production. Our trade model so
extended is referred to as the Heckscher–Ohlin model.

8. 5.2 Assumptions of the Theory
A. The Assumptions
1) There are two nations (1&2), two commodities (X&Y), two factors of
production (labor & capital).
Used to illustrate the theory in a two-dimensional figure.
2) Both nations use the same technology in production.
Means both nations have access to and use the same general production
techniques.
3) Commodity X is labor intensive and Y is capital intensive in both nations.
Means the labor-capital ratio (L/K) is higher for X than Y in both nations at the
same relative factor prices.

9. 4) Both commodities are produced under constant returns to scale in
both nations.
Means that increasing the amount of L and K will increase output in the
same proportion
5) There is incomplete specialization in production in both nations.
Means that even with free trade both nations continue to produce both
commodities. This implies neither nation is very small.
6) Tastes are equal in both nations.
Means demand preferences are identical in both nations. When relative
prices are equal in the two nations, both consume X&Y in the same
proportion.

10. 7) There is perfect competition in both commodities and factor
markets in both nations.
Means that producers, consumers, and traders of X&Y in both nations are
each too small to affect prices of commodities. Also, in the L-R
commodity prices equal their costs, leaving no economic profit.
8) There is perfect factor mobility within each nation but no
international factor mobility.
Means K&L are free to move from areas and industries of lower earnings
to those of higher earnings until earnings are the same in all areas, uses
and industries of the nation. International differences in earnings persist
due to zero international factor mobility in the absence of international
trade.

11. 9) There are no transportation costs, tariffs, or other obstructions to the free
flow of international trade.
Means specialization in production proceeds until relative (and absolute)
commodity prices are the same in both nations with trade. If transportation costs
and tariffs were allowed, specialization would proceed only until prices differed
by no more than the costs and tariffs on each until of the commodity traded.
10) All resources are fully employed in both nations.
Means there are no unemployed resources in either nation.
11) International trade between the two nations is balanced.
 Means that the total value of each nation’s exports equals the total value of the
nation’s imports.

12.  Comment
On the basis of these assumes, the Heckscher-Ohlin theorem predicted that
the capital surplus country specializes in the production and exports of
capital intensive goods, and the labor surplus country specialize in the
production and exports of labor intensive goods.

13. MOHAMMAD WASHIM
ID: B-120203045

14. 5.3 Factor Intensity, Factor Abundance, and
the Shape of the Production Frontier (PF)
A. Factor Intensity
 In a world of 2 commodities and 2 factors, Y is capital intensive if its (K/L)
is greater than (K/L) of X.
 If production of Y requires 2K and 2L, then K/L=1.
 If production of X requires 1K and 4L, then K/L=1/4.
 We say that Y is K intensive and X is L intensive.
 Measuring K and L intensity depends on K/L rather than the absolute
amount of K and L.
 In fig. 5-1, Nation 1 can produce 1Y using 2K-2L, and 2Y using 4K-4L.
Thus, K/L=1, this gives the slope of Y in Nation 1.

15. FIGURE 5-1 Factor Intensities for Commodities X and Y
in Nations 1 and 2.
Nation 1 can produce 1X using 1K-4L, and 2X using 2K-8L. Thus, K/L=1/4, this
gives the slope of the ray of X in Nation 1.
 In Nation 2, K/L=4 for Y and 1 for X.

16. FIGURE 5-1 Factor Intensities for Commodities X and Y
in Nations 1 and 2.
Therefore, Y is the K-intensive commodity, and X is the L-intensive in Nation 2
also. This is shown by the fact that the ray from the origin for good Y is steeper than
that of X in both nations.

17. FIGURE 5-1 Factor Intensities for Commodities X and Y
in Nations 1 and 2.
 Even though Y is K-intensive relative to X in both nations, Nation 2 uses a higher K/L than Nation 1.
 For Y, K/L=4 in Nation 2 but K/L=1 in Nation 1.
 For X, K/L=1 in Nation 2 but K/L=1/4 in Nation 1.

18. B. Factor Abundance
 Two ways to define factor abundance:
1) In terms of physical units (i.e. overall amount of K&L (TK/TL) available to each
nation).
 According to this definition, Nation 2 is capital abundant if the ratio of total amount
of capital to total amount of labor available in Nation 2 is greater than that in
Nation 1.
 The ratio of TK/TL what is important , not the absolute amount of K&L available in
each nation.
 Thus, Nation 2 can have less K than Nation 1 and still be the capital abundant
nation if TK/TL in Nation 2 exceeds TK/TL in Nation 1.

19. 2) In terms of relative factor prices (i.e. rental price of K (PK) and the price of L time (PL) in each
nation).
 According to this definition, Nation 2 is K abundant if (PK/PL) is lower in Nation 2 than in
Nation 1.
 Since rental price of K is taken to be the interest rate (r) and the price of labor time is wage
(w), then PK/PL= r/w.
 The ratio r/w what is important , not the absolute level of r that determines whether a nation is
K abundant.
 The first definition considers only the supply of factors, while the second definition considers
both demand and supply.
 The demand of the factor is derived from demand for the final commodity that requires the
factor in its production.

20. C. Factor Abundance and the Shape of the Production Frontier
 Since Nation 2 is K-abundant and Y is K-intensive, Nation 2 can produce relatively
more of Y than Nation 1.
 Since Nation 1 is L-abundant and X is L-intensive, Nation 1 can produce relatively
more of X than Nation 2.
 This gives a production frontier for Nation 1 that is relatively flatter and wider that that
of Nation 2.

21. FIGURE 5-2 The Shape of the Production Frontiers of
Nation 1 and Nation 2.

22. AFRIN KHAN
ID: B-120203137

23. The Heckscher-Ohlin Theory
 Heckscher-Ohlin (H-O) theory is based on two theorems:
1. The H-O theorem
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.
In short, the relatively labor-rich nation exports the relatively labor-intensive
commodity and imports the relatively capital-intensive
commodity.
Explains comparative advantage rather than assuming it.

24. For example, if we imagine commodity X is labor intensive commodity and nation
1 produces it, on the other hand nation-2 produces commodity Y which is capital
intensive commodity. here L is available and cheap factor in nation 1 and so is K in
nation 2.
Now H-O Theorem says that, Nation-1 will export X
because X is the L-intensive
commodity and L is relatively abundant
and cheap factor in Nation 1.
Nation-1
and Nation-2 will export Y because Y is
the K-intensive commodity and K is relatively
abundant and cheap factor in Nation 2.
Nation-2

25. FIGURE 5-3 General Equilibrium Framework of the
Heckscher-Ohlin Theory.
General equilibrium
framework of the H-O Theory
1. The tastes and the distribution
in the ownership of factors of
production together determine the
demand for commodities.
2. The demand for commodities
determines the derived demand
for the factors required to produce
them.

26. FIGURE 5-3 General Equilibrium Framework of the
Heckscher-Ohlin Theory.
3. The demand for factors of
production, together with the
supply of factors, determines the
price of factors of production
under perfect competition.
4.The price of factors of
production, together with
technology, determines the price
of final commodities.
5.The difference in relative
commodity prices between nations
determines comparative advantage
and the pattern of trade.

27. General equilibrium framework of the H-O Theory
Figure 5.3 shows clearly how all economic forces jointly determine the price of
final commodities. This is what is meant when we say that the H–O model is a
general equilibrium model.
However, out of all these forces working together, the H–O theorem isolates the
difference in the physical availability or supply of factors of production among
nations to explain the difference in relative commodity prices and trade among
nations. Specifically, Ohlin assumed equal tastes among nations.

28. GAZI RAFSAN SHAHAB
ID: B-120203071

29. C. Illustration of the Heckscher-Ohlin Theory
 Since the two nations have equal tastes, they face the same indifference map.
 Indifference curve I is the highest IC that Nation 1 and Nation 2 can reach in
isolation, and points A and A/ represent their equal. points of production and
consumption in the absence of trade.
 The tangency of IC I at points A and A/ defines the no-trade equal-relative
commodity prices of PA in Nation 1 and PA/ in Nation 2.
 Since PA < PA/ , Nation 1 has a com-adv. in X and Nation 2 has a com-adv. in Y.

30. C. Illustration of the Heckscher-Ohlin Theory
FIGURE 5-4 The Heckscher-Ohlin Model.
The right panel shows that with trade Nation 1 specializes in X and Nation 2 in
Y.
Specialization continues until Nation 1 reaches point B and Nation 2 B/, where
the transformation curves are tangent to the common relative price line PB.

31. C. Illustration of the Heckscher-Ohlin Theory
FIGURE 5-4 The Heckscher-Ohlin Model.
Nation 1 exports X in exchange for Y and consume at point E on IC II. Nation 2 exports
Y for X and consume at point E/ (which coincides with point E).
Note that Nation 1’s exports of X equal Nation 2’s imports of X (i.e. BC=C/ E /).
Similarly, Nation 2’s exports of Y equal Nation 1’s imports of Y (i.e. B/C/ =C E).

32. C. Illustration of the Heckscher-Ohlin Theory
FIGURE 5-4 The Heckscher-Ohlin Model.
At PX/PY > PB, Nation 1 want to export more of X than Nation 2 wants to import at this
high relative price, and PX/PY falls towards PB.
At PX/PY < PB, Nation 1 want to export less of X than Nation 2 wants to import at this
low relative price, and PX/PY rises towards PB.

33. C. Illustration of the Heckscher-Ohlin Theory
FIGURE 5-4 The Heckscher-Ohlin Model.
Point E involves more of Y but less of X than point A
However, Nation 1 gains from trade because E is on higher IC II.
Similarly, at E/ which involves more X but less Y than A/, Nation 2 is better of
because E/ is on higher IC II.

34. TAJRIMA SULTANA SRISTI
ID: B-120203043

35. 5.5 Factor-Price Equalization and Income Distribution
The factor price equalization theorem
International trade will bring about equalization in the relative and
absolute returns to homogenous factors across nations.
In short, wages and other factor returns will be the same after
specialization and trade has occurred.
Holds only if H-O theorem holds.

36. 5.5 Factor-Price Equalization and Income Distribution
The factor price equalization theorem
International trade causes w to rise in Nation 1 (the low-wage nation) and fall
in Nation 2. (the high-wage nation), reducing the pre trade difference in w
between nations.
Similarly, trade causes r to fall in Nation 1 (the K-expensive nation) and rise
in Nation 2. (the K-cheap nation), reducing the pre trade difference in r
between nations.
Thus, international trade causes a redistribution of income from the
relatively expensive (scarce) factor to the relatively cheap (abundant)
factor.

37. Factor Price equalization Theorem
Relative and Absolute Factor-Price Equalization
FIGURE 5-5 Relative Factor–Price Equalization.
The horizontal axis measures w /r and the vertical axis PX /PY . Before trade, Nation 1 is at point A,
with w /r = (w /r )1 and PX /PY = PA while Nation 2 is at point A` , with w /r = (w /r )2 and PX /PY
= PA`.
Since w /r is lower in Nation 1 than in Nation 2, PA is lower than PA` so that Nation 1 has a
comparative advantage in commodity X.

38. Factor Price equalization Theorem
Relative and Absolute Factor-Price Equalization
FIGURE 5-5 Relative Factor–Price Equalization.
As Nation 1 specializes in the production of commodity X with trade and increases the
demand for labor relative to capital, w /r rises. As Nation 2 specializes in the production of
commodity Y and increases its relative demand for capital, r /w rises (i.e., w /r falls). This
will continue until point B = B` , at which PB = PB` and w /r = (w /r )∗ in both nations.

39. Factor Price equalization Theorem
Relative and Absolute Factor-Price Equalization
FIGURE 5-5 Relative Factor–Price Equalization.
PX/PY will become equal as a result of trade, and this will only occur
when w/r has also become equal in the two nations (as long as both
nations continue to produce both commodities).

40. Comment
The Heckscher-Ohlin Theory & Factor Price equalization Theory
 According to the H–O theorem, a nation will export the commodity intensive in its
relatively abundant and cheap factor and import the commodity intensive in its
relatively scarce and expensive factor.
 According to the factor–price equalization (H–O–S) theorem, international trade
will bring about equalization of relative and absolute returns to homogeneous
factors across nations.

41. ASIBUL ISLAM MILU
ID: B-120203034

42. 5.5c Effect of International Trade on distribution of
Income
 International trade on the effect of relative factor prices within each nation
 Trade increases the price of the nation’s abundant and cheap factor and reduces the
price of its scarce and expensive factor. W rises and r falls in Nation 1 while w falls
and r rises in Nation 2. International trade on the effect of income within each nation.
 The real income of labor and the real income of owners of capital move in the same
direction as the movement in factor prices. Trade causes the real income of labor to
rise and the real income of owners of capital to fall in Nation 1 while in Nation 2 the
situation is the opposition.

43. 5.5c Effect of International Trade on distribution of
Income
 International trade on the effect of relative factor prices and the distribution of
income within each nation in the long run;
 According to H-O-S theorem, international trade causes real wages and the real
income of labor to fall in a capital-abundant and labor –scarce nation (such as
developed countries). On the contrary, international trade causes real interests
and the real income of capital to fall in a labor-abundant and capital scarce
nation (such as developing countries);
 Unequal distribution of income needs an appropriate distribution policy of the
government.

44. EHSUN HOQUE
ID: B-110203091

45. 5.5 Factor-Price Equalization and Income
Distribution
 5.5D Specific Factors Model
 Trade will:
 have an ambiguous effect on a nation’s mobile factors,
 benefit the immobile factors specific to a nation’s export commodities or
sectors, and
 harm the immobile factors specific to a nation’s import-competing commodities
or sectors.

46. Specific Factors Model
 In the short run when some factors may be immobile Or specific
to some industry or sector. In this case, it Assumes that trade will
have an ambiguous effect on the nation’s mobile factors : It will
benefit the immobile factors that are specific to the nation’s export
commodities or sectors, and harm the immobile factors that are
specific to the nation’s import-competing commodities or sectors.

47. Specific Factors Model
 In the long run when all input are mobile among all Industries of a nation,
the H-O model postulates that the opening of trade will lead to an increase
in the real income or return of the inputs used intensively in the nation’s
export sectors and to a reduction in the real income or return of the inputs
used intensively in the production of the nation’s import-competing sectors.

48. RAJIB HUSSAIN
ID: B-120203032

49. 5.6 Empirical Tests of the H-O Model
5.6A. The Leontief Paradox
(1) Empirical test byWassily Leontief (1951)
 Data: U.S. data for the year 1946.
 Hypothesis: Since the U.S. was the most K-abundant nation in the world, it was
expected that the U.S. exported K-intensive commodities and imported L-intensive
commodities.
 Test method: Calculated the amount of labor and capital in a ‘representative
bundle’ of $1 million worth of U.S. exports and import substitutes for the year
1947.
 - Result: U.S. import substitutes were more K-intensive than U.S. exports.
 This is called the Leontief paradox.

50. Empirical Tests of the Heckscher-Ohlin Model
 Source of the Leontief Paradox Bias
Assumed a two factor world which required assumptions about what is
capital and what is labor.
Most heavily protected industries in U.S. were L- intensive, reduced
imports and increased domestic production of L-intensive goods.
Only physical capital included as capital, ignoring human capital
(education, job training, skills).

51. 5.6 Empirical Tests of the H-O Model
 Implications of the conflicting empirical results
The H-O model is useful in explaining international trade in
raw materials, agricultural products which is large
component of trade between developing and developing
countries.

52. Explanations of the Leontief Paradox
 The used data was not representative;
 Two-factor model (L, K) , ignoring the natural resources; (Many
production process using natural resources)
 U.S. Trade policy (heavy protection of domestic labor-intensive
industries, so more labor –intensive goods export);
 Only the measure of physical capital and ignoring the human capital and
“knowledge” capital;
At the same time there are many strong and convincing evidences verifying
H-O theory.

53. Comment
The first empirical test of the H–O model was conducted by Leontief using 1947
U.S. data. Leontief found that U.S. import substitutes were about 30 per- cent more
K intensive than U.S. exports. Since the United States is the most K -abundant
nation, this result was the opposite of what the H–O model predicted; this became
known as the Leontief paradox.
Empirical results seem to show that the traditional Heckscher–Ohlin model can
explain trade between developed and developing countries (often referred to as
North–South trade) and a highly qualified or restricted version of the H–O
can model the much larger trade among developed countries (i.e., North–North
trade).

54. SUJAN BHUIYAN
ID: B-120203055

55. 5.6C Factor-Intensity Reversal
• Factor-intensity reversal refers to the situation where a commodity is L intensive
in the L-abundant nation and K intensive in the K -abundant nation.
• This may occur when the elasticity of substitution of factors in production varies
greatly for the two commodities. With factor reversal, both the H–O theorem and
the factor–price equalization theorem fail.
• Some tests show that factor reversal was fairly prevalent, some tests provide
strong confirmation of the H-O model.

56. 5.6C Factor-Intensity Reversal
 In the absence of factor intensity reversals, the Heckscher-Ohlin theorem is
valid on the basis of the price definition of factor abundance. The identity of
tastes between countries is unnecessary to assume in this case.
 In the absence of factor intensity reversals, the Heckscher-Ohlin theorem is true
on the basis of the physical definition of factor abundance only if the tastes are
homogenous and similar between countries.
 In the presence of factor intensity reversals, the Heckscher-Ohlin theorem is
not generally valid.