EU trade and Ukraine

Chapter 1: ECONOMIC BASES OF TRADE

1.4. The Heckscher-Ohlin Model


The Ricardian model has two short comings: 

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 

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:

Assumptions H-O Model

Shoes (QS), Computers (QC)

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. 

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). 

 

 

 

Production Possibility Frontier (PPF): Increasing Opportunity Economy

 

 

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:

= QSproduced if all resources are allocated to shoes production 

= 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 than(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

Heckscher-Ohlin Theorem:

Each country will exportthe good that uses its abundant factor intensively.

 To show this let’s make the following assumptions:

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*. 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)< 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.

 


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