3.1 The Heckscher-Ohlin Theory and Its Implications

The Heckscher-Ohlin Model

We saw earlier that the immediate basis for the pattern of trade was that relative product prices differed between two countries before trade. This initial difference might be due to differences in production, or demand, or some combination of these factors. We represent production conditions – influenced by resource availability and technology – by the production possibilities frontier. Similarly, we represent demand conditions by community indifference curves, which reflect a nation’s preferences. Therefore, the eventual determinants of comparative advantage are resource availability, technology, and demand. The standard theory of trade focuses on production as the basis for the initial pre-trade price differences and assumes that demand conditions are similar across countries.

The Heckscher-Ohlin model assumes that we are dealing with a world in which two countries are producing two goods, using two resources (e.g., capital and labour). The resources are mobile within each country but not internationally. While resource endowments are different in the two countries, they are fully employed within each country. Perfect competition exists in all markets, which implies that products and resources are essentially the same (i.e., homogeneous), prices are given, information is readily available, and firms are free to enter and exit any industry in response to changes in profits.

A country is resource-abundant if it has a higher ratio of a specific resource to other resources than does the rest of the world (Pugel, 2020). For instance, if Canada has a higher ratio of capital to labour than the rest of the world (i.e., [latex]\text{KC}/\text{LC}>\text{KRoW}/\text{LRoW}[/latex]), then Canada is capital-abundant, and the other country is capital-scarce. A product is resource-intensive if the resource cost represents a greater share of its value than it does for other products (Pugel, 2020). If [latex]\text{(K/L)m} >\text{(K/L)a}[/latex], where [latex]\text{m}[/latex] and [latex]\text{a}[/latex] denote manufacturing and agriculture, respectively, then the manufacturing industry is capital-intensive, and agriculture is labour-intensive. When a resource is abundant, its relative cost is low, and the prices of the products that intensively use that resource will also be low. This, of course, makes sense intuitively: If a country has a lot of a resource, then that resource will be relatively cheap, and if a significant amount of that resource is used in production, then the resulting products will also be cheap.

The Ricardian model (see Chapter 2) and the standard theory indicate that the opening up of international trade causes shifts in production within the country and provides benefits for some groups while other groups experience losses. The export sector expands in light of the additional demand from foreign buyers, while the import-competing sector contracts due to the availability of foreign supplies in the domestic market. The beneficiaries in this situation are the producers of the exported good and the consumers of the imported product. Meanwhile, the losers are the domestic consumers of the exported good and the domestic producers of the imported good.

While it projects similar shifts in production between sectors as well as gains and losses in well-being because of trade, the H-O theory also provides us with greater insight into the potential winners and losers from international trade. Specifically, it goes beyond the basic distinction between producers and consumers and helps us to understand how international trade affects earnings based on the ownership of productive resources. The H-O theory also demonstrates how production and economic well-being can change over time – from the short run to the long run – and this is in contrast to the static analysis of the Ricardian and standard models (Pugel, 2020; Carbaugh, 2015).

Given initial differences in relative product prices, the opening of international trade alters production within trading countries. The export sector that uses abundant resources intensively benefits from low costs and increased production. Meanwhile, the import sector that uses the scarce factor intensively experiences higher-cost production and becomes smaller. Moreover, the changes in production are different in the short run from those in the long run.

In the short run, while the sizes of the two sectors change, the extent of the growth or contraction is limited by the resources currently engaged in the production in the respective sectors. In the long run, resources move between sectors in response to available returns, which allows for a fuller adjustment to occur. The result is that the export sector expands further while the import sector continues to shrink.

In the short run, groups tied to the expanding sector gain while those tied to the shrinking sector suffer losses. As resources employed in the expanding and contracting sectors shift as prices change in the long run, rising supplies of the resource used intensively in the expanding sector will cause its returns to fall back from their higher short-run levels. Conversely, the price of the factor used intensively in the shrinking sector will rise from its lower short-run levels. In the long run, the price of the factor used intensively in the expanding sector rises. However, the price of the factor used intensively in the contracting sector falls. In summary, international trade will make some groups better off and others worse off in absolute terms.

Implications of the Heckscher-Ohlin Model

In this section, we set out the major implications of the H-O theory in terms of the Stolper-Samuelson theorem, specialized factor pattern, and factor price equalization theorem.

The effects of trade on the distribution of factor income are summarized in the Stolper-Samuelson theorem. This theorem states that an event that changes relative product prices in a country has two clear effects:

• It raises the real income of the factor used intensively in the industry where price is rising; and
• It lowers the real income of the factor used intensively in the industry where price is falling.

This theorem suggests that while international trade may provide gains in well-being for a nation, there are definite winners and losers. An extension of the Stolper-Samuelson theorem is the “magnification effect.” which holds that the change in the price of a resource will be greater than the change in the price of the product that uses the resource intensively in its production (Carbaugh, 2015).

An important assumption of the H-O theory is that resources are free to move between sectors within a particular country. However, while such factor movement may take place in the long run, in many instances, resources are effectively immobile in the short run. The specialized factor theorem, which addresses this issue, states the following:

• The more a factor is concentrated in producing a good whose relative price is rising, the larger the gain accruing to this factor due to the increase in the good’s price; and
• The more a factor is concentrated in producing a good whose relative price is falling, the more it stands to lose from a decrease in the good’s price.

International trade shifts demand away from the scarce resource and toward the abundant resource. In each trading partner, this boosts the price of the resource that was cheap before trade and lowers the price of the resource that was expensive before trade. Eventually, this process causes the price of the same resource to equalize across countries. the factor-price equalization theorem states that free trade equalizes the prices of the individual production factors between two trading partners, implying that the owners of a particular resource will earn the same income in all trading countries even though resources were immobile across countries.

However, factor price equalization does not hold in the real world for a number of reasons. Among trading countries, labour is not of the same quality and technology and trade policies are usually different. In addition, transportation costs can prevent product prices from equalizing. Still, there is a general tendency for factor prices to move toward equality between countries over time. For instance, while indices of hourly compensation indicate significant differences across countries, wages in the manufacturing and information technology sectors in China and India, respectively, have risen relative to those in the United States (Pugel, 2020; Carbaugh, 2015).

Researchers have done a number of studies that have examined whether the core result of the H-O theory is borne out in the real world. Countries with relatively large resource endowments tend to export products that embody large amounts of those resources. In the 1950s, Wassily Leontief conducted the first test using U.S. data and two factors of production – capital and labour. Leontief expected to find that the United States, given its presumed relative abundance of capital, would export capital-intensive products and import labour-intensive ones. However, the results of the initial study failed to confirm the result of H-O theory. Leontief found that U.S. imports were more capital-intensive than U.S. exports, a result that was labelled the Leontief paradox.

Leontief and other researchers conducted further tests of the H-O theory which involved more countries and more factors of production. They believed the view that the pattern of international trade should reflect the unequal distribution of resources across countries if the H-O theory were valid. These tests showed that international trade patterns were more consistent with the prediction of the H-O theory in that countries tended to export products that used their abundant resources intensively. Given the greater disaggregation of the factors of production, the United States exports were found to be skill-intensive products, reflecting an abundance of human capital and superior technology.

References

Carbaugh, R.J. (2015). International economics, (15th ed.). Cengage Learning.

Pugel, T. A. (2020). International economics, (17th ed.). McGraw-Hill.