CHAPTER F I V E

5 International
Economics
Tenth Edition

Factor Endowments and the

Heckscher-Ohlin Theory
Dominick Salvatore
John Wiley & Sons, Inc.
Learning Goals:

 Explain how comparative advantage is based on

differences in factor endowments across nations
 Explain how trade affects relative factor prices
within and across nations
 Explain why trade is likely to be only a small
reason for higher skilled-unskilled wage
inequalities
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
Introduction

 Extending trade model to include:

 Basis of comparative advantage
 Effect of international trade on return to labor
Assumptions of the Theory

 Heckscher-Ohlin theory based on following

assumptions:
1. Two nations, two goods, two factors of
production
2. Technology is the same in both nations
3. Commodity X is labor intensive, commodity Y is
capital intensive in both nations (K/L ratio lower
(higher) for X (Y)
4. Constant returns to scale for X and Y in both
nations (a 10% in L&K for X, X will by 10%)
5. Incomplete specialization in production in both
nations (neither of two nations ‘small’)
Assumptions of the Theory

 Heckscher-Ohlin theory based on following

assumptions (continued):
6. Tastes are the same in both nations (both nations
consume X & Y in same proportion)
7. Both commodities and factors are traded in perfectly
competitive markets
8. Perfect factor mobility within each nation, but not
between nations
9. No transportation costs, tariffs or other barriers to
free trade.
10. All resources are fully employed in both nations
11. International trade between the nations is balanced.
Factor Intensity, Factor Abundance, and the
Shape of the Production Frontier

 Factor Intensity
 In a two-commodity, two factor world,
commodity Y is capital intensive if the capital-
labor ratio (K/L) used in the production of Y is
greater than K/L used in the production of X.

 It is not the absolute amount of capital and labor

used in production of X and Y, but the amount of
capital per unit of labor that determines capital
intensity.
FIGURE 5-1 Factor Intensities for Commodities X and Y
in Nations 1 and 2.
Factor Intensity, Factor Abundance, and the
Shape of the Production Frontier

 Factor Abundance (can be defined in two

ways)
 In terms of physical units:
 Nation 2 is capital abundant if the ratio of the
total amount of capital to the total amount of
labor (TK/TL) available in Nation 2 is greater
than that in Nation 1.

 It is not the absolute amount of capital and

labor available in each nation, but the ratio of
the total amount of capital to the total amount
of labor.
Factor Intensity, Factor Abundance, and the
Shape of the Production Frontier

 Factor Abundance
 In terms of relative factor prices:
 Nation 2 is capital abundant if the ratio of the
rental price of capital to the price of labor time
(PK/PL) is lower in Nation 2 than in Nation 1.

 Rental price of capital is usually considered to

be the interest rate (r), while the price of labor
time is the wage rate (w), so PK/PL = r/w.
 It is not the absolute level of r that determines
whether a nation is K-abundant, but r/w.
 Nation 2 is K-abundant, and
commodity Y is K-intensive

Nation 1 is L-abundant, and

commodity X is L-intensive

FIGURE 5-2 The Shape of the Production Frontiers of

Nation 1 and Nation 2.
Factor Endowments and 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.
Factor Endowments and the Heckscher-Ohlin
Theory

 Heckscher-Ohlin (H-O) theory is based on

two theorems:
1. The H-O theorem
 In short, the relatively labor-rich nation exports
the relatively labor-intensive commodity and
imports the relatively capita-intensive
commodity
 Explains comparative advantage rather than
assuming it.
FIGURE 5-3 General Equilibrium Framework of the
Heckscher-Ohlin Theory.
FIGURE 5-4 The Heckscher-Ohlin Model.
Factor-Price Equalization and Income
Distribution

 Heckscher-Ohlin (H-O) theory is based on

two theorems:
2. 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.
Factor-Price Equalization and Income
Distribution

 Heckscher-Ohlin (H-O) theory is based on

two theorems:
2. 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 pretrade
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 pretrade difference
in r between nations.
Factor-Price Equalization and Income
Distribution

 Heckscher-Ohlin (H-O) theory is based on

two theorems:
2. The factor price equalization theorem
 Thus, international trade causes a
redistribution of income from the relatively
expensive (scarce) factor to the relatively cheap
(abundant) factor.
FIGURE 5-5 Relative Factor–Price Equalization.
Factor-Price Equalization and Income
Distribution

 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.
Empirical Tests of the Heckscher-Ohlin Model

 The Leontief Paradox

 A 1951 test of the H-O theory
 Showed that the pattern of trade did not fit the
conclusions of the H-O theorem.
 Exports in the U.S. seemed to be labor intensive
when they should have been capital intensive.
Empirical Tests of the H-O Model

 The Leontief Paradox Bias

 Empirical test by Wassily 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.
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).
Case Study 5-7 Capital and Labor Requirements
in U.S. Trade
Case Study 5-1 Relative Resource
Endowments of Various Countries
Case Study 5-2 Capital-Labor Ratios of
Selected Countries
FIGURE 5-9 Specific-Factors Model.
FIGURE 5-10 Factor-Intensity Reversal.
 Factor Intensity Reversal
At w/r= ½, X (K/L=6/18) is produced at A and Y at B (K/L=9/12). So X is L-intensive
and Y K-intensive.
At w/r=2, Y is produced at C (K/L=12/9) and X at D (K/L=18/6). Thus X is K-
intensive and Y is L-intensive
This is called FIR.
With FIR, H-O theorem and Factor price eq. do not hold.
At w/r=1/2, Nation 1 is L-abundant and Nation 2 is K-abundant at w/r= 2.
So nation 1 should produce and specialize in the production of X being the labor
abundant and X as L-intensive.
While at w/r=2, Nation 2 is K-abundant and it should produce X as it is K-intensive
product there.
So both nations cannot export same quantity to each other, so H-O does not predict
pattern of trade.
In case of FPE theorem, it also does not hold. When nation 1 specializes in X, its low
wages w increase as demand for L increases (w/r). So if Nation 1 specializes in X,
Nation 2 must specialize in Y, but Y is L-intensive commodity there too, so demand for
labor increases there, so w/r and w also increase there. So wages rise in both nations.