Resources and Trade: The Heckscher-Ohlin Model: © Pearson Education Limited 2015

Chapter 5
Resources and
Trade: The
Heckscher-Ohlin
Model
• © Pearson Education Limited 2015. All rights reserved. 1-1

Preview
• Production possibilities
• Changing the mix of inputs
• Relationships among factor prices and
goods prices, and resources and output
• Trade in the Heckscher-Ohlin model
• Factor price equalization
• Trade and income distribution
• Empirical evidence

Introduction
• In the Ricardian model, trade occurs because countries

have labor with different productitivty levels. Cross
country difference in productivity is the main source of
trade.
– Spesific Factor Model covered up the single-resource (only
labor) assumption of the Ricardian model by taking multiple
resources (capital, land, etc.) into consideration.
– The Ricardian model doesn’t explain why countries’ resources
are different in terms of productivity. Why is labor low
productive in one country but not in the other?
– The Ricardian model assumes the different production
function (and the same factor intensity of goods across
country (for one unit of cloth, the same quantity of labor and
capital is used). It doesn’t explain why cloth is produced
using relatively more capital in one country but relatively less
capital in the other.
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 resources and 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.

Introduction
Assumptions
The Ricardian Model The H-O Model
Perfect Competition
Full Employment
Homogenious Goods
Zero Transportation Cost
Factors of production are mobile within countries but immobile accross countries
Constant return to scale
Homogenious factor of production
2x2x1 2x2x2 (two goods, two countries, two factors)

Similar production function across
Diffrent production functions across countries countries
(different productivity of factor of production (factors of production have the same level of
(or labor) across countries productivity across countries: labor
productivity is the same everywhere.)
Countries are different in terms of factor
Most important endowmnets.
(relative abundance of factors of production)
assumptions of
Goods are different in terms of factor
H-O intensity. (there are labor intensive goods and
capital intensive goods. But a labor intensive good
contains relatively more labor in one country but it
contain relatively less labor in the other)

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.
5. The supply of labor and capital in each country is
constant and varies across countries.
6. In the long run, both labor and capital can move
across sectors (no spesific facor), equalizing their
returns (wage and rental rate) across sectors.

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?

PP: A numerical Example
Production QC =QC (KC , LC) K and L are

function in mobile across
each sector QF =QF (KF , LF)
sectors.
K and L K = 3000 and L = 2000

supply
Use of a fixed
aKC = 2, capital used for one unit of cloth
Food is a
mix of capital aLC = 2, labor used for one unit of cloth capital-
and labor in intensive
each sector relative to
(unit factor aKF = 3, capital used for one unit of food cloth
requirements) aLF = 1, labor used for one unit of food (relatively
. labor-
intensive)

Production Possibilities (cont.)
• Production possibilities are influenced by both

capital and labor:
aKCQC + aKFQF ≤ K Total amount of

capital
resources
Capital used Capital used
Total calories
for each yard Total yards of for each
of food
of cloth cloth calorie of food
production
production production production
Total amount
aLCQC + aLFQF ≤ L of
labor
Labor used for Labor required resources
each yard of for each calorie
cloth production of food
production
Used capital
cannot
exceed capital 2QC + 3QF ≤ 3000 Both K and L
supply.
have
And used
labor cannot 2QC + QF ≤ 2000 constraints.
exceed labor
supply.
• Without factor substitution, the PP

curve is the interior of the two factor
cosntraints.

The Production Possibility Frontier
without Factor Substitution
2QC + QF ≤ 2000

2QC + 3QF ≤ 3000

• 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 food and 750
cloth (point 3).

• At point 1, the
economy specializes
in food, and not all
available work-hours
are employed.
• At point 2, the
economy specializes
in cloth, and not all
available machine-
hours are employed.
• At point 3, the
economy employs all
of its labor and
capital resources.

The opportunity cost of

producing one more
cloth, in terms of food,
is not constant:
• low (2/3) when the
economy produces
less cloth and more
food
• high (2) when the
economy produces
more cloth and less
food.

• The opportunity cost

of producing one
more yard of cloth, in
terms of food, is not
constant. Why?
• Because when the
economy devotes
more resources
towards production of
one good, the
marginal productivity
of those resources
tends to be low so
that the opportunity
cost is high.

• 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
increases as producers
make more cloth.

The Production Possibility
Frontier with Factor Substitution
If producers can substitute one
input for another in the production
process, then the PPF is curved
(bowed).
Opportunity cost of cloth

increases as producers make
more cloth.
What does the

country
produce?

Prices and Production
• What does the country
produce?
• 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 given the
prices it faces.
V = PC QC + PF QF
– The opportunity cost of
cloth is equal to the slope
of isovalue line is
– (PC /PF)

Prices and Production
• 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.

Choosing the Mix of Inputs
• Producers may choose
different amounts of
factors of production used
to make cloth or food.
• A farmer can produce one
unit of food with less
capital if he uses more
labor, and vice versa.
• Their choice 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.

Choosing the Mix of Inputs
• Assume that at any
given factor prices, cloth
production uses more
labor relative to capital
than food production
uses:
aLC /aKC > aLF /aKF
or
LC /KC > LF /KF
• Production of cloth is
relatively labor
intensive, while
production of food is
relatively capital
intensive.

Factor Prices and Input Choices
• In each sector, the L/K ratio

depends on the cost of labor
relative to capital (w/r).
• FF shows the L/K ratio
choices in food. CC shows
the L/K ratio choices in cloth.
• At any given wage-rental
(w/r) ratio, cloth production
uses a higher L/K ratio. This
means cloth is labor-
intensive and food is capital-
intensive.
• Relative factor demand curve
for cloth CC lies outside that
for food FF.

Factor Prices and Goods Prices
• In
competitive markets, the price of a good
should equal its cost of production (factor
prices).
• How changes in w and r affect the cost of
producing a good depends on the mix of
factors used.
– An increase in r should affect more than since
food is the capital intensive industry.
• Changes in w/r are tied to changes in
PC /PF.

Because cloth is labor-

intensive and food is capital-
intensive, there is a one-to-
one relationship between
the factor price ratio (w/r)
and the relative price of
cloth (PC /PF).
The higher the relative cost

of labor, the higher must be
the relative price of the
labor-intensive good.
This relationship is
illustrated by the SS curve.

(cont.)
• How do distribution of income change when
the relative price of goods change?
• Stolper-Samuelson theorem: If the
relative price of a good increases, then the
real wage or rental rate of the factor used
intensively in the production of that good
increases, while the real wage or rental rate
of the other factor decreases.
• Any change in the relative price of goods
alters the distribution of income.

Stolper-Samuelson theorem

Suppose the economy produces both goods. Given , the w/r must be equal
to . This wage-rental ratio implies that K/L ratio in cloth and food must be
and .
If the relative price

of cloth rises to ,
the w/r must rise to
. This will cause the
L/K ratio used in
both goods to drop.
In sum, given
output prices, we
can determine not
only factor prices,
but factor levels in
the Heckscher-Ohlin
model.

An increase in the relative price of

cloth, PC /PF, is predicted to • raise income of
workers relative
to that of capital
owners (w/r).
• raise the K/L ratio
used in both
industries.
• raise the real
income
(purchasing
power) of workers
and lower the real
income of capital
owners.

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.
– Generally, an economy wil tend to be relatively effective at
producing goods that are intensive in the factors with which the
country is relatively well endowed.

Rybczynski theorem
• Assume an economy’s labor force grows, which

implies that its ratio of labor to capital L/K
increases.
• Expansion of production possibilities is biased
toward cloth.
• At a given relative price of cloth, the ratio of labor
to capital used in both sectors remains constant.
• 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).

Resources and Production
Possibilities: Rybczynski theorem
• An increase in the supply
of labor shifts the
economy’s production
posibility frontier outward
from to , but does so
disproportionately in the
direction of cloth
production.
• The result is that at an
unchanged relative price
of cloth (indicated by the
slope -), food production
actually declines from to .

Resources and Production
Possibilities: Rybczynski theorem
• An economy with a high
L/K ratio produces a high
output of cloth relative to
food.
• Suppose that Home is
relatively abundant in
labor and Foreign in
capital:
L/K > L*/ K*
– Home is relatively
scarce in capital and
Foreign in labor.
• Home will be relatively
efficient at producing cloth
because cloth is relatively
labor intensive.

Trade in the Heckscher-Ohlin
Model
• 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.
• The only difference between the countries is in
their resources: Home is labor abundant while
Foreign is capital abundant.
– Note that abundance is defined in terms of a K/L ratio not in
absolute quantities.

Trade in the Heckscher-Ohlin Model
(cont.)
• 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.
– 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.

Trade Leads to a Convergence of
Relative Prices (H-O Model)
• Home will have a larger
relative supply of cloth
because cloth is labor-
intensive and Home is
labor abundant.
• Home becomes an
exporter of cloth
because it is labor-
abundant (relative to
Froreign). Foreign
becomes an exporter of
food because it is
capital-abundant.
• Home’s relative supply
curve, then, lies to the
right of Foreign’s.
• In the absence of trade,

Home’s equilibrium would
be at point 1, where
domestic relative supply
RS intersects the relative
demand curve RD.
• Similarly, Foreign’s
equilibrium would be at
point 3.
• Trade leads to a world

relative price that lies
between the pretrade
price and , such as at
point 2.

• Like the Ricardian

model, the Heckscher-
Ohlin model predicts a
convergence of relative
prices with trade.
• With trade, the relative
price of cloth rises in
the relatively labor
abundant (home)
country and falls in the
relatively labor scarce
(foreign) country.

(cont.)
• 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.
• The decline in the relative price of cloth in
Foreign leads it to become an importer of
cloth and an exporter of food.

(cont.)
• Heckscher-Ohlin theorem: The country

that is abundant in a factor exports the
good whose production is intensive in that
factor.
• 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 and the Distribution of
Income
• How does trade affect distribution of
income?
– Stolper-Samuelson theorem: If the relative
price of a good increases, then the real wage or
rental rate of the factor used intensively in the
production of that good increases, while the real
wage or rental rate of the other factor
decreases.
• Any change in the relative price of goods alters the
distribution of income.
• Trade affects distribution of income to the
extend that it affects the relative prices
Income
• Changes in relative prices can affect the earnings
of labor and capital.
– A rise in the price of cloth raises the purchasing
power of labor in terms of both goods while
lowering the purchasing power of capital in
terms of both goods.
– A rise in the price of food has the reverse effect.

Income (cont.)
• Thus, 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.

Income (cont.)
• 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.

Income (cont.) CASE STUDY
• Changes in income distribution occur with every

economic change, not only international trade.
– Changes in technology, changes in consumer preferences,
exhaustion of resources and 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 US.
• 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.

Income (cont.) CASE STUDY
• There is a political bias in trade politics:

potential losers from trade are better
politically organized than the winners from
trade.
– Losses are usually concentrated among a few,
but gains are usually dispersed among many.
– Each of you pays about $8/year to restrict
imports of sugar, and the total cost of this policy
is about $2 billion/year.
– The benefits of this program total about $1
billion, but this amount goes to relatively few
sugar producers.

North-South Trade and Income
Inequality CASE STUDY
• Over the last 40 years, countries like South Korea,

Mexico, and China have exported to the U.S. goods
intensive in unskilled labor (ex., clothing, shoes,
toys, assembled goods).
• At the same time, income inequality has increased
in the U.S., as wages of unskilled workers have
grown slowly compared to those of skilled workers.
• Did the former trend cause the latter trend?

Inequality (cont.) CASE STUDY
• 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.
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.

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:
– Wages of skilled labor have increased more
rapidly in Mexico than wages of unskilled labor.
– But compared to the U.S. and Canada, Mexico

is supposed to be abundant in unskilled
workers.

3. Even if the model were exactly correct, trade is a

small fraction of the U.S. economy, so its effects
on U.S. prices and wages prices should be small.
• 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 CASE STUDY
• Even though skilled labor becomes relatively more

expensive, in panel (b) producers in both sectors
respond to the skill-biased technological change by
increasing their employment of skilled workers
relative to unskilled workers.
– The trade explanation in panel (a) predicts an
opposite response for employment in both
sectors.
• A widespread increase in the skilled labor ratios for
most sectors in the U.S. economy points to the
skill-biased technological explanation.

Skill-Biased Technological Change and
Income Inequality (cont.) CASE STUDY
• Trade likely has been an indirect contributor to

increases in wage inequality, by accelerating the
process of technological change.
– Firms that begin to export may upgrade to more skill-
intensive production technologies.
– Trade liberalization can then generate widespread
technological change by inducing a large proportion of
firms to make such technology-upgrade choices.
• Breaking up the production process across
countries can increase the relative demand for
skilled workers in developed countries similar to
skill-biased technological change.

Increased Wage Inequality: Trade or Skill-
Biased Technological Change? CASE STUDY

Evolution of U.S. Non-Production–Production
Employment Ratios in 4 Groups of Sectors CASE STUDY

Factor Price Equalization (by
Samuelson)
• Unlike the Ricardian model, the Heckscher-Ohlin
model predicts that factor prices will be equalized
among countries that trade.
• Free trade equalizes relative output prices.
• Due to the connection between output prices and
factor prices, factor prices are also equalized.
• 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.

Samuelson)
• 1# H-O predicts a specialization pattern based on
factor abundance
– Trade leads Home to specialize in labor-intensive cloth
and Foreign to specialize in capital-intensive food.
Because Home is labor-abundant and Foreign is capital-
abundant.
• 2# The H-O model predicts a convergence of
relative prices with trade.
– With trade, the relative price of cloth rises in the relatively
labor abundant (home) country and falls in the relatively
labor scarce (foreign) country.

Samuelson)
• 3# Due to the change in relative price, the demand
for Home’ s cloths increases in Foreing market
while the demand for Foreign’s foods increases in
Home market.
• 4# Stolper-Samuelson theorem predics the effect
of price change on the income distribution.
─ When the relative price of cloth rises, the relative earning
(w/r) of labor rise in Home while the relative earnings of
capital rises in Foreign.
• 5# Finnaly, as countries trade, the relative prices
of goods converge.
─ This convergence, in turn, causes convergence of the
relative price of labor and capital until a total equalization
between countries.
Samuelson)
• Samuelson draw a very logical outcome from H-O
by developing Factor Price Equalization. But in the
real world, factor prices are not equal across
countries. Why?
– The model assumes that trading countries produce the set
of goods, but countries may produce different set of goods
if their factor ratios radically differ.
– 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.

Samuelson)
– The model assumes that factors of production are
homogenious (no quality difference).
– The model assumes free trade (no barrier to trade). Due
to natural barriers such as transportation cost, trade
policy (tariffs, quotas) and other restrictions, the prices of
good are not fully equalized.
– 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.

Empirical Evidence on the
Heckscher-Ohlin Model
• The essence of H-O is that trade is driven

by differences in factor abundance across
countries.
• FPE (derived from H-O) predicts that the
trade in goods is a substitution for the
factor trade. International trade leads to the
same outcome as international factor
mobility.
• Since the emprical evidences don’t confirm
FPE predictions, does this mean H-O don’t
explain the trade pattern? Not at all.

•• Setting an emprical test for H-O
– If H-O hold, a labor abundant country must export labor-
intensive goods and a capital abundant country must
export capital-intensive goods, so on.
• How to measure factor intencity?
– Physical Definition:
Home exports capital-
⇒ K/L in Home’s export > K/L in Home’s import intensive goods and
– Economic Definition: imports labor-intensive
goods
Foreign exports labor-
intensive goods and
imports capital-
intensive goods


•• Tests on US data: Leontief Paradox
– If the US is a capital-abundant economy, it must be an
exporter of capital-intensive goods (and be an importer of
labor intensive-goods) since capital is a cheaper factor
than labor. Thus K/L ratio must be higher in exported
goods than in imported goods.
– Leontief found that U.S. exports were less capital-

intensive than U.S. imports, even though the U.S. is the
most capital-abundant country in the world: Leontief
paradox.

"≯≯"
"≯≯"
Factor Content of U.S. Exports

and Imports for 1947
Tests on US data: Leontief Paradox
Exports Imports
Capital stock 2,550,780 mil.$ 3,091,339 mil.$
Labor 182,213 year of labor 170,004 year of labor
K/L ratio 14,010 18,180
𝐾 𝐾
( )
𝐿 𝐸𝑥𝑝𝑜𝑟𝑡
( )
≯
𝐿 𝐼𝑚𝑝𝑜𝑟𝑡𝑠
Estimating K/L ratio for US export sector and import competing sector, Leontief
realized the first test for H-O.
The result is shocking: as opposite to popular belive (or H-O prediction), the USA
was an exporter of labor-intensive goods and an importer of capital-intensive
goods! This is a paradox!
Isn’t the USA a capital abundant county!?

"≯≯"
"≯≯"
Factor Content of U.S. Exports

and Imports for 1962
• Reason for Leontief Paradox:
• Leontief tested H-O for the year 1947 (just after WWII!)
• He considered only capital and labor as factors. But the
US is abundant in land, underground sources.
• He considered factors as homogenious. But if we classify
labor for example into skilled and unskilled labor, the
US is abundant in high skilled workers that are mostly
used in capital intensive goods.
• H-O is based on free trade. But there are barriers to
trade such as tariff, transportation cost, geographical
difficulties, wars and conflicts,etc.
• Instead of calculating the factor composition for import
sector, he took into consideration the factor composition
of import competing (domestic) sector because of the
statistical difficulty.
How to measure factor abundance?
• Physical Definition:
⇒ Home is capital abundant.
• Economic Definition:
Home is capital abundant.
• Leamer approach: If a country has a higher K/L ratio

in production than in comsumption, this county is a
capital abundant.
• Vanek approach: A country’s world share of a spesific
factor exceeds its world income share, then this
country is abundant in that factor.
> =%24>%22

⇒ Home is capital abundant.

> =%24>%22

USA has a comperative
advantage in R&D
intensive products.

Estimated Technological Efficiency,
1983 (United States = 1)
• Tests on global data: Bowen, Leamer, and Sveikauskas
(1987)
• BLS (1987) tested the Heckscher-Ohlin model on data
from 27 countries and and 12 factors of production. They
adopted Vanek approach
• This confirmed the Leontief Paradox on the global scale.
The factor-proportions theory predicts that the U.S.
should export capital-intensive goods. However, Leontief
found that the U.S. actually exported labor-intensive
goods.
• In addition to the Leontief, BLS (1987) contradict the
factor-proportions theory.
• BLS (1987) confirms Leontief Paradox (rejection of H-O
factor proportion prediction) by 61% of the cases
whereas supporting the factor proportion theory by 39%
of the cases.

Estimated Technological Efficiency,
1983 (United States = 1)
• Tests on global data: Trefler (1995)
• Trefler (1995) performs several diagnostic
tests on the data to determine which
assumptions of the H-O model is most likely
to be responsible for its failure (Leontief
(1951) and BLS (1987)) , and concludes that
the assumption of equal technologies across
countries is especially bad.
• Accordingly, he develops an extended version
of the H-O model that allows for different
technologies across countries.

Estimated Technological Efficiency, 1983
(United States = 1)
There are two ways that technological differences can

be introduced into the H-O:
1) modeling the productivity of factors in different
countries;
2) modeling the differences in the factor of
requirements.
• Both approaches are closely related, of course (saying that
a factor is 10% less productive in one country is the same
as saying that 10% more of that factor is needed per unit
of production. Trefler takes the firts approach).
• Adopting the firts, Trefler estimated a set of countries’

factor productivity relative to that of the US.
• Labor productivity in Bangladesh is 4% of the US’ level.

Estimated Technological Efficiency, 1983
(United States = 1)
Teretler (1995) results

for labor productivity:
The horizontal axis

shows the estimated
productivity of labor
while the vertical axis
shows wage levels.
Since there is a high

corelation (0,9)
between the two
variables, we conclude
that cross-country
differences in wages
reflect workers’
productivities

Empirical Evidence of the
Heckscher-Ohlin Model (cont.)
• Tests on global data: Davis and Weinstein (2001)

• H-O predicts that factors of production will produce and export a certain
quantity goods until factor prices are equalized.
• If H-O (and thus FPE) is true, then there should be a strong corelation
between the factor composition of countries and their trade values. The
factor proportions should reflect the potential export and import values
for each countries.
• If there is a difference between the potential trade values, predicted by
the H-O and the actual trade value, the difference is called «missing
trade».
• Missing trade means that a country exports more (or less) that it should
do.
• Davis and Weisntein (2001) tested the validity of H-O model by
estimating «missing trade».

• The empirical test is done for the trade flows between 10

OECD countries and the rest of world. Only capital and
labor is considered as factor of production.
• The emprical test is done based on the relaxation of three

assumption of H-O (and FPE):
1) the same technology across country;
2) the same set of goods are porduced by countries;
3) under free trade, zero transport equalizes good
prices.

The estimation based on The estimation based on the The estimation based on
three assumption: H-O assumption 2 and 3: H-O the assumption 3: H-O
explains 32% of total trade but explains 50% of total trade but explains 86% of total trade.
cannot explain 68% of it. cannot explain 50% of it. And the actual trade is 19%
of the potential trade.
Additionally, the actual trade The actual trade value is only
value is only 0,005% of the 0,08% of the potential trade The estimation based on
potential trade value! H-O value!Relaxing the assumption the assumption 2: H-O
unrealistically predicts much 1 strenghtened the prediction of explains 91% of total trade.
more trade than it could be. H-O. And the actual trade is 69%
of the potential trade.


– The study 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
prediction of H-O becomes more compatible with emprical
evidence.
– Difficulty finding support for the predictions of the “pure”
H-O model can be blamed on some of the assumptions
made.

The exports of three developing to the US • Tests on global data:
are concentrated in the sectors with the lowest-skilled labor while
that of three developed countries are in the sector with the Romalis (2004)
highest skilled labor.
• 2x2x2 model, the H-O
predicts that the country
abundant in a factor
exports the good whose
production is intensive in
that factor.
• John Romalis (2004)
adopted this prediction for
multiple countries and
multiple goods case.
• Results: as a country’s
skill abundance increases,
its exports are increasingly
concentrated in sectors
with higher skill intensity.

Or compare how exports
change when a country
such as China grows and
becomes relatively more
skill-abundant:
• 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.
Summary
1. Substitution of factors used in the production

process generates a curved PPF.
– When an economy produces a low quantity of a good,
the opportunity cost of producing that good is low.
– When an economy produces a high quantity of a good,
the opportunity cost of producing that good is high.
2. When an economy produces the most value it can
from its resources, the opportunity cost of
producing a good equals the relative price of that
good in markets.

Summary (cont.)
3. An increase in the relative price of a good causes

the real wage or real rental rate of the factor used
intensively in the production of that good to
increase,
– while the real wage and real rental rates of other factors
of production decrease.
4. If output prices remain 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.

Summary (cont.)
5. An economy exports goods that are relatively

intensive in its relatively abundant factors of
production and imports goods that are relatively
intensive in its relatively scarce factors of
production.
6. Owners of abundant factors gain, while owners of
scarce factors lose with trade.
7. A country as a whole is predicted to be better off
with trade, so winners could in theory
compensate the losers within each country.

Summary (cont.)
8. The Heckscher-Ohlin model predicts that relative

output prices and factor prices will equalize,
neither of which occurs in the real world.
9. Empirical support of the Heckscher-Ohlin model is
weak except for cases involving trade between
high-income countries and low/middle- income
countries or when technology differences are
included.

Theorems derived from H-O
• Factor Prices Equalization (Samuelson,

1948)
– Trade increases the demand of goods produced
by relatively abundant factors. The increase in
the demand for a good rises the demand for the
factor used intensively in that good. And rise in
the demand for that factor increases the price of
it.
– If trade rises the price of the abundant factor in
in both country, factor prices as well as prices of
goods will equalize.

• Exception for FPE:

– Factor Intensity Reversal (Case 1)
• If factors are substituable for each other when the
relative prices change, FPE doesn’t occure.
– Thailand exports labor-intensive good (textile). But
if the world demand for its good increases, Thai
textile producers firts demand more for labor. As the
the price of labor increases they want to use more
machines and less labor. Textile becomes capital
intensive.
– If labor is substituable for capital in labor abundant
country and capital is substituable for labor in
capital abundant country, trade doesn’t equalize the
factor prices.


• H-O assumes that although both countries have both
factors, one exports labor-intensive good (textile) other
exports capital intensive good (otomobile).
• If FIR holds, then textile can becomes capital intensive.
Labor abundant country and capital abundant country
exchage capital-intensive goods (textile for otomobile)


• H-O assumes that goods are different in terms of factor
intensity. (there are labor intensive goods and capital
intensive goods. But a labor intensive good contains
relatively more labor in one country but it contain
relatively less labor in the other)
• If FIR holds, it becomes possible that both counties
trade the same homogenious good. One country
produces it as labor intensive good while other country
produces it as capital intensive good.

• Income Distirbution (Stolper-Samuelson,

1941)
– Free trade increases the return of factor used
intensively in the production of exported good.
But protectionism increases the return of factor
used intensively in import competing sector.
• Free trade is favorable for the intensively used factor in
export sector whereas protectionism is favorable for the
intensively used factor in import competing sector.
• Free trade is good for the abundant factor where as
protectionism is good for the scarece factor in a
country.

• Exception for Stolper-Samuelson theorem

– Spesific Factor Model: SS (and H-O) explains
the effect of trade on income distribution by
assuming that factors are mobile across sectors
but immobile across countries.
• This assumption cannot be valid in the short term.
Because some factors are spesific to their sectors.
• Spesific Factor Model predicts that the effect of trade is
– positive for the immobile factor in exporting industry
– negative for the immobile factor in import
competing industry
– ambigious for the mobile factor

• Exception for Stolper-Samuelson theorem

– Meltzer Paradox: Stolper-Samuelson (and H-O)
is valid in the case of two countries with equal
economic sizes.
– In the case of small/big country:
• If the small country reduces its export price (in order to
keep its market share) after the big country imposed a
tariff on imports, the import substitute good becomes
chaper in the big country.
• Protectionism (tariff) won’t increases the return of the
intensively used factor in import competing sector. SS
fails!

• Rybezinski Theorem (1955)

– In a 2x2x2 model, under full employment, as the
amount of a factor increases, then the supply of
the good that uses this factor intensively
increases and the supply of the other good
decreases.
• Rybezinski theorem studies the impact of growth on
trade.
– As the supply of factor intensively used in export
sector increases, the supply of exported goods
increases. The exporting country exchages more
goods for its same amount of imports. (Is it good?)

Criticisms on the 2x2x2 H-O Model
• The essential H-O model assumes

homogenious factor of production.
– The model essentially ignored skilled/unskilled
labor, high fertil/low fertil arable lands, etc.
– Productivity differences of the same factor
generalize an extra gain from trade out of the H-
O model.
– Differences in productivity of the same factor
allows for different cost of production for the
same good across countries.
– This missing point is recently included into the
model.
• The Cambridge capital controversy:

– The consideration of capital in H-O causes
problems. It results from the
inhomogeneous nature of capital. But H-O
says if capital is abundant then it is
cheaper. How can we determine whether
capital is abundant or not?


– If capital is homogeneous, then we can
use K/L ratio (physical definition).
Newertheless, it is not homogenious.
Because 1) Capital includes not only
machines but also all other goods (every
good can be used in production of other
goods). 2) Even machines are not
homogenious.


– In this case we can consider capital as
«money» (economic definition). The i is
lower if capital is abundant.
– But it causes a new problem: since the
price of money is interest rate, it is
affacted by many other factors in addition
to the relative abundance of capital.


– In H-O, capital supply is fixed and capital is
regarded as a non-produced endowment.
• If capital is considered a «producible
factor», then in the long term, the
abundance/scarcity of capital is not a
matter of question!
• Event thougt capital is scarece, it is only in
the shor term.
– If capital is a producible endowment, then H-
O fails.
• The essential H-O model assumes the same

technology (the same level of productivity of
factors across countries) across country.
– Actually, production technics differ across
counties. This is not a realistic assumption and
yields emprically poor outcomes.

• H-O is rather a supply-side model.

– If in both countries consumption preference
(demand) for goods are different, the prices of
those goods don’t reflect their costs.

• If the relative prices of factors don’t reflect

the the relative factor endowment of
countries, the model fails.
– If there is a high demand for labor in the labor
abundant country, wage is no longer low. This
causes «factor intensity reversal».
– Factor-Intensity Reversal: as the price of a factor
increases (labor), producers substitutes cheaper
factor (capital) for expensive factor. At the end,
labor-intensive industry can become capital-
intensive. Factor intensity of goods revers.

• H-O assumes constant-return to scale.

– As the trade begins, countries’ demand for each
orther’s good increase. A a larger demand allows
for a larger scale in the specialized indutries, cost
of production can eventually decrease
(economies of scale).
– Due to economies of scale, countries
comparative advantage can change.

• H-O assumes constant-return to scale.

– As the trade begins, countries’ demand for each
orther’s good increase. A a larger demand allows
for a larger scale in the specialized indutries, cost
of production can eventually decrease
(economies of scale).
– Due to economies of scale, countries
comparative advantage can change.

Chapter 5
Appendix: Factor
Prices, Goods Prices,
and Production
Decisions

Fig. 5A-1: Choosing the Optimal
Labor-Capital Ratio

Fig. 5A-2: Changing the Wage-Rental
Ratio

Fig. 5A-3: Determining the Wage-
Rental Ratio

Fig. 5A-4: A Rise in the Price of
Cloth

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Chapter 5

• © Pearson Education Limited 2015. All rights reserved. 1-1

• © Pearson Education Limited 2015. All rights reserved. 1-2

• In the Ricardian model, trade occurs because countries

• In addition to differences in labor productivity,

• © Pearson Education Limited 2015. All rights reserved. 1-4

• © Pearson Education Limited 2015. All rights reserved. 1-5

• © Pearson Education Limited 2015. All rights reserved. 1-6

• With more than one factor of production,

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Production QC =QC (KC , LC) K and L are

K and L K = 3000 and L = 2000

• © Pearson Education Limited 2015. All rights reserved. 1-8

• Production possibilities are influenced by both

aKCQC + aKFQF ≤ K Total amount of

• Without factor substitution, the PP

• © Pearson Education Limited 2015. All rights reserved. 1-10

• © Pearson Education Limited 2015. All rights reserved. 1-11

2QC + 3QF ≤ 3000

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• Max food production

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The opportunity cost of

• © Pearson Education Limited 2015. All rights reserved. 1-15

• The opportunity cost

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• The above PPF equations do

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Opportunity cost of cloth

What does the

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• © Pearson Education Limited 2015. All rights reserved. 1-20

• © Pearson Education Limited 2015. All rights reserved. 1-21

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• In each sector, the L/K ratio

• © Pearson Education Limited 2015. All rights reserved. 1-23

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Because cloth is labor-

The higher the relative cost

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• © Pearson Education Limited 2015. All rights reserved. 1-26

• © Pearson Education Limited 2015. All rights reserved. 1-27

If the relative price

• © Pearson Education Limited 2015. All rights reserved. 1-28

An increase in the relative price of

• © Pearson Education Limited 2015. All rights reserved. 1-29

• How do levels of output change when the

• © Pearson Education Limited 2015. All rights reserved. 1-30

• Assume an economy’s labor force grows, which

• © Pearson Education Limited 2015. All rights reserved. 1-31

• © Pearson Education Limited 2015. All rights reserved. 1-32

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• Since cloth is relatively labor intensive, at

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• In the absence of trade,

• Trade leads to a world