CHAPTER 5:  FACTOR ENDOWMENTS & HECKSCHER-OHLIN THEORY

-What determines comparative advantage (i.e. why are relative prices of Y and X different in nation 1 and 2)
-The effects of trade on factor (K and L) earnings.
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  • Assumptions of H-O Theory.

    •   1. 2 nations (1 and 2), 2 commodities (Y and X) and 2 factors ( K and L)
      2. Both nations use the same technology in producing Y and X.
      3. Good X is L-intensive, Y is K-intensive.
      4. Production functions have constant returns to scale.
      5. Incomplete specialization in production in both nations.
      6. Tastes (preferences) equal in both nations (same set of IC).
      7. Perfect competition in factor and goods markets.
      8. Perfect factor mobility within a nation, no international factor mobility.
      9. No transportation costs, tariffs or other barriers (completely free trade)
    10. All resources fully employed (no unemployment, capital fully utilized)
    11. Trade between the 2 nations is balanced (NX=0 in both nations).
     
  • Factor Intensity


    • -If the K/L ratio is larger in production of good Y compared to good X => Y is K-intensive & X is L-intensive.
     

  • Factor Abundance

    • 2 ways to define factor abundance:
    1) physical units (total amount of K and L in a nation) (relative supply of L and K).
    2) relative factor prices (i.e. prices of L and K):  (r/w)
        (determined by supply and demand of L and K, thus, it is better than (1)).

    -If preferences (demand) are the same in each nation => (1) or (2) can be used.
     -example: Same demand curve in each nation.
                   If  (Total K/Total L) in nation 2 is greater than in nation 1=> (r/w) is LESS in nation 2.

    -If preferences not the same in both nations, use (2) to determine which nation is K or L abundant.
     

  • Factor Abundance and shape of PPF


    • Given that  Nation 2 is K-abundant & nation 1 is L-abundant : Nation 2 can produce RELATIVELY more of Y than nation 1
    &
    nation 1 can produce RELATIVELY more of X than nation 2.
    -PPF for nation 2 is skewed towards Y good (K-intensive)
    -PPF for nation 1 is skewed towards X good (L-intensive)
     

  • Heckscher-Ohlin Theory


    • -If (r/w) is less in nation 2 => (Py/Px) in nation 2 is lower than in nation 1 (= (Px/Py) is higher in nation 2).
     (ch. 2: since (Py/Px) is less in nation 2 => nation 2 has comparative advantage in Y)
    H-O THEOREM: Nation 2 will export Y (K-intensive good)
                                 Nation 1 will export X (L-intensive good)

    -In equilibrium (where NX=0), relative  and absolute factor prices (r/w) will be equal.
      In nation 1: r will decrease and w will increase (=> r/w  increases)
      In nation 2: r will increase and w will decrease (=> r/w  increases)

    -Who gains from trade and who loses:
     In nation 1 (L-abundant): labor gains (since w increases) and capital owners lose (since r falls)
     In nation 2 (K-abundant): capital owners gain ( since r increases) and labor loses (since w falls).

    CASE STUDY 5-5: Has International Trade Increased U.S. Wage Inequalities?
       -Fact: real wage of college graduates has been increasing relative to real wage of high-school graduates.
       -Table 5.5 shows: 10.1% due to trade (37.7% due to technological change). Source WSJ, Oct. 31, 1997, p.A2.

    -Testable Implication of H-O model:
    U.S. should export goods with higher K/L ratio than the K/L ratio used in imported goods.
    Leontief Paradox: Used K/L ratios in exported goods and import substitutes (goods imported but also produced in U.S.) to test the model.
    He found the opposite, i.e. the K/L ratio in exported goods was LESS than the ratio used in import substitutes.
    But including human capital solves the paradox.

    -Factor Intensity reversal
    -H-O theory assumes K/L ratio for one good (Y) is always greater than the K/L ratio for the other good (X) at all factor prices (i.e. for all r/w).
    But: this may not be true if the substitution of K for L is very different in production of each good.
    example: use isoquants with different degree of substitution and see what happens to K/L ratio as r/w changes.