The Ricardian model has two short comings:
- First, it does not allow for the study of the effects of trade on income distribution; everyone gains from trade in the Ricardian model, while we know in the real world some people lose from trade.
- Second, the Ricardian model does not explain differences in labour productivity amongst countries. In the real world, part of labour productivity is due to the resource endowment. Labour productivity is higher in countries with higher capital or land endowments.
- In addition, the constant opportunity cost is not a desirable property in the Ricardian model. This property leads to compete specialization which we do not observe very often in the real world.
Swedish Econ History Eli Heckscher (article 1919) and his student Bertil Ohlin who developed these ideas in his 1924 dissertation.
Explained trade on the bases of difference in resource endowment
- Shows that comparative advantage is influenced by:
- Relativefactor abundance(refers to countries)
- Relativefactor intensity(refers to goods)
- Is also referred to as the factor-proportions theory
The Heckscher-Ohlin modelallows studying the impact of trade on income distribution and it partially explains labour productivity based on capital endowment. The main result of H-O model is expressed in H-O theorem. This theorem states that for example a capital-abundant country exports the capital-intensive good while the labour-abundant country exports the labour-intensive good.
Here's why:
- A capital-abundant country=> higher relative supply of K-intensive goods
- => Lower relative price of k-intensive good before trade
- The H-O theorem demonstrates that differences in resource endowments (as defined by national abundances) can be a reason for international trade to occur.
Assumptions H-O Model
- Two goods: An economy can produce two goods,
Shoes (QS), Computers (QC)
- Two Countries: Home and Foreign
- Two Factors of Production:
The production of these goods requires two inputs labour Land Capital K.
Supply of the two inputs are given and fixed
The two factors are perfectly mobile domestically (a long run view is taken here) within countries and immobile between countries.
- Technology
Same technologyin both countries.
Constant Returns to Scale (CRS) production functions:
QS = QS(LS, KS)
QC = QC(LC, KC)
Production of computer is capital-intensive,and production of shoe is labour-intensivein both countries.LC/KC<LS/KS, (e.g., wage share of production cost in higher in shoes compared to computers)
These two curves slope down just like regular demand curves, but in this case, they are relative demandcurves for labour (i.e., demand for labour divided by demand for capital).
- That is the labour/labour content in shoes are larger than computers.
- Perfect competition prevails in all markets and no transportation cost.
- The two countries differ only in their factor endowments (same tastes, same tech)
Production Possibility Frontier (PPF): Increasing Opportunity Economy
- Opp Cost of Shoes in terms of Computer increases as more computers are produced.
- Why do we get this result? Because resources are not equally suitable for production of all good!
Why PPF represents increasing opportunity cost? Why PPF is not a straight line? To see this consider will show that can do better than E (above the line) in the figure above:
A = QSproduced if all resources are allocated to shoes production
B = QCproduced if all resources are allocated to computer production
E = (½ A and ½ B) if ½ of all the resources (½ of all K and ½ of all L) are
allocated to shoes and the other half to computers
Can do better thanE (North East of E up to the PPF), if in shifting resources from K-intensive computers to L-intensive shoes if less than ½ capital and more than ½ Labour is released to the shoes sector.
PPF, Resource Endowment and Technology
In general, PPF of two countries can be different for reasons of resource endowment or technology. Countries with identical resources and technology have identical PPF. To see how PPF’s of two countries might be different consider the following exercises:
a) an increase in Labour endowment;
b) an increase in capital endowment;
c) an improvement in technology of production.
Equilibrium before International Trade
- In absence of international trade, the production mix of computers and shoes depends on domestic demand. In this economy demand is such that production takes place at point A on PPF, where PPF is tangent to the highest indifference curve.
- The slope of the PPF at the point of tangency determines domestic relative price of computers: PC/PS.
- Note that this line, GG’ also measures the value of mix of production at point A. That is GG’ represents GDP when production takes place at point A.
- To see this notice that: GDP = PC QC1+PSQS1
Heckscher-Ohlin Theorem:
Each country will exportthe good that uses its abundant factor intensively.
To show this let’s make the following assumptions:
- There are two countries (Home and Foreign) with:
- Sametastes & Sametechnology
- And Different factor endowment
- In particular let’s assume L/K <L*/K*
- i.e. Home is Capital Abundant, Foreign is CapitalScarce
Then under these assumptions the theorem implies that Home country exports capital intensive computers and imports labour intensive shoes.
Before trade
Home production and consumption takes place at point A at autarky price ratio of PC/PS. Before trade Foreign production and consumption takes place at point A* at autarky price ratio of P*C/P*S . Since Home is relatively Labour scarce (capital abundant) its autarky relative price of Computer would be lower than that of the Foreign country PC/PS<P*C/P*S.
Before Trade Production and Consumption in Home and Foreign Country
Once trade opens up Home will export Computers and Foreign will export Shoes. International prices will be somewhere between the autarky prices of the two countries: PC/PS< (PC/PS)W<P*C/P*S
Post-Trade: Production and Consumption of Home and Foreign Country
At (PC/PS) < (PC/PS)W < P*C/P*S capital abundant Home exports capital intensive computer and Labour abundant Foreign exports Labour intensive shoes.
Aggregate Economic Efficiency
The H-O model demonstrates that when countries move to free trade, they will experience an increase in aggregate efficiency.
The change in prices will cause a shift in production of both goods in both countries.
Each country will produce more of its export good and less of its import goods.
Unlike the Ricardian model, however, neither country will necessarily specialize in production of its export good.
As a result of the production shifts though, productive efficiency in each country will improve. Also, due to the changes in prices, consumers, in the aggregate will experience an improvement in consumption efficiency.
In other words,national welfare will rise for both countries when they move to free trade.
However, this does not imply that everyone benefits. Later we will show some factor owners will experience an increase in their real incomes while others will experience a decrease in their factor incomes.
Trade will generate winners and losers. The increase in national welfare essentially means that the sum of the gains to the winners will exceed the sum of the losses to the losers. For this reason, economists often apply the compensation principle.
The compensation principle states that as long as the total benefits exceed the total losses in the movement to free trade, then it must be possible to redistribute income from the winners to the losers such that everyone has at least as much as they had before trade liberalization occurred.