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Describe the Heckscher-Ohlin model and explain the Heckscher-Ohlin Theorem. Provide a critique of the assumptions of the model. Is the Heckscher-Ohlin Theorem robust to the underlying assumptions? Explain and illustrate important points by using diagrams. Based on this critique, analyse the relevance of the model for policymakers.

Developed in the 1920’s by Swedish Economists Eli Heckscher and Bertil Ohlin, and further developed by Paul Samuelson, the Heckscher-Ohlin model attempts to provide more realistic explanations of trade than that of the previous conventional wisdom: the Ricardian Model of Comparative Advantage. Supplementing Ricardo’s model with two key assumptions, namely the introduction of two factors of production (capital and labour), and the necessity that production technology be identical in both countries, the model was able to show that trade and comparative advantage will result from the relative international difference of factor endowments instead of differing labour productivity.

By introducing two factors of production the model is often referred to as the 2x2x2 model (two countries, two commodities and two factors of production), the first three of many assumptions necessary for the model to hold, the rest are listed below as a precursor to succinctly describing the model:

· Each country possesses a fixed supply of the two factors (capital (K) and labour (L)), but their capital to labour ratios differ. Both factors are fully employed and can be substituted in production

· Perfect competition in the factor and commodity markets

· Production technology is identical in both countries, and exhibit Constant

Returns to Scale (CRS)

· One of the commodities is labour intensive and the other is capital intensive, at all input prices. There are no factor intensity reversals

· Preferences are identical and homogenous in both countries

· Perfectly mobile factors within the country, but perfectly immobile internationally

· There are no barriers to free trade, and zero transportation costs

With identical technologies the model neutralises the possibility of a Ricardian comparative advantage, and the introduction of a second factor produces the familiar neoclassical concave production function (in accordance with diminishing marginal products). This results in a more realistic scenario where both countries produce both commodities (unless endowments are radically different) rather than complete specialisation.

Further developing the framework we state that the UK has a higher capital to labour ratio (K/L) than China (Equation 1.1), resulting in an autarky

(K/L)_UK > (K/L)_CHINA (1.1)

scenario where the UK is endowed with relatively cheap capital and China relatively cheap labour in accordance with diminishing marginal products. Additionally the commodities are differentiated by factor intensities, commodity X shall be labour intensive and Y capital intensive (1.2)

(K/L)_Y > (K/L)_X (1.2)

The accumulation of these conditions generates the following Production Possibility Frontiers (PPFs)

(Figure 1.1)

noting that each country is biased towards the production of the commodity that is factor intensive for the same factor that the country is abundant in. It is important to maintain that this model generates trade via relative endowment differences and thus absolute sizes of each PPF are irrelevant in determining the direction of trade but relevant with regard to the terms of trade.

With the PPFs established it is necessary to derive the autarky equilibriums (A_UK and A_CHINA), specifically what each country produces and consumes without trade. Remembering assumptions for identical and homothetic preferences and perfect competition, production and consumption for each country occurs where

MRS = MRT (1.3)

which corresponds diagrammatically in Figure 1.2 to points A_UK and A_CHINA, where the indifference curves are tangent to the respective PPFs. The resulting tangency slope generates the autarky price ratios for each country (P_UK and P_CHINA).

(Figure 1.2)

The important result to derive here is that the differing of resource endowments was sufficient to produce differing autarky equilibrium price ratios (1.3), which is sufficient to generate incentive for international trade.

P_UK > P_CHINA (1.3)

where P = (P_X/P_Y)

With autarky equilibrium established the effects of trade are now examined. Given (1.3) UK consumers notice that commodity X is cheaper in China they will prefer to import X instead of purchase it domestically as long as it remains cheaper in China (vice-versa for China and Y). Hence trade will occur until price ratios are equalised at a level where excess supply and demand are matched, producing an international price ratio P*[1] for both countries such that:

P_CHINA < P* < P_UK (1.4)

.

In order for this to occur the change in demand from autarky to free trade must be accompanied by a change in production from both countries. China will respond to the increasing demand for X by increasing its production relative to Y, since X has become relatively more valuable (vice versa for the UK). This continues until

P*=MRT (1.5)

and thus final production occurs at their tangency (Q_UK,Q_CHINA in Figure 1.3). Similarly final consumption (C_UK, C_CHINA) will occur where

MRS = P* (1.5)

Thus resulting in free trade equilibrium

P* = MRS = MRT (1.6)

The final result is succinctly explained by Figure 1.3, noting that both countries are consuming on higher indifference curves than before, producing uneven[2] but overall welfare gains. Observing that the UK exports commodity Y and imports X the result is in accordance with the Heckscher-Ohlin theorem which states that

“Given the assumptions of the model, a country will export the commodity that intensively uses its relatively abundant factor” Markusen et al. (1995, p. 106)