Advertising Economics Jobs / Economist Jobs Help

<!– /* Style Definitions */ p.MsoNormal, li.MsoNormal, div.MsoNormal {mso-style-parent:”"; margin:0in; margin-bottom:.0001pt; mso-pagination:widow-orphan; font-size:10.0pt; font-family:”Times New Roman”; mso-fareast-font-family:”Times New Roman”;} p.MsoHeader, li.MsoHeader, div.MsoHeader {margin:0in; margin-bottom:.0001pt; mso-pagination:widow-orphan; tab-stops:center 3.0in right 6.0in; font-size:10.0pt; font-family:”Times New Roman”; mso-fareast-font-family:”Times New Roman”;} @page Section1 {size:8.5in 11.0in; margin:1.0in 1.25in 1.0in 1.25in; mso-header-margin:.5in; mso-footer-margin:.5in; mso-paper-source:0;} div.Section1 {page:Section1;} –>

Whilst this result is intuitively simple the model has drawn substantial criticism particularly since Leontief’s (1953) empirical analysis and subsequent Leontief paradox, which demonstrated that capital to labour ratios did not determine the patterns of trade. In defence of the basic premise of the Heckscher-Ohlin model is the belief that the assumptions of the model are too romantic (which country exhibits perfect competition!), and that relaxing some of them can easily reverse the result of the model.

Firstly by relaxing the identical technology assumption the effective capital to labour ratios will be altered by for example greater human capital or higher capital factor productivity, in essence varying the levels of total factor productivity (TFP). Re-specifying the capital to labour ratio will alter the shape of the PPF, as shown by Figure 1.4, where a capital abundant country becomes labour abundant with human capital considered (Keesing (1965) showed that the US possessed a comparative advantage in skilled labour). The result on trade is ambiguous depending on how much TFP is allowed to vary, but if the difference is sufficiently biased the direction of trade may reverse (Figure 1.4b). Considering the vast disparities in development between countries it is surprising that this was not incorporated into Leontief’s study. Empirical studies by Maskus and Webster (1999) and Trefler (1993) highlight the relevance of different technologies.

(Figure 1.4)

Similarly if the identical preferences are relaxed, it is plausible for sufficient taste bias to exist to warrant a reversal in the direction of trade – known as a demand reversal, where the capital intensive country imports the capital intensive product as a result of its preferences, as shown by Figure 1.5. Quasi-homogenous preferences could also reverse trade and explain trade of capital intensive products between developed countries.

(Figure 1.5)

Relaxing the 2x2x2 assumptions to allow for an arbitrary but equal number of commodities and factors, and potentially infinite number of countries, generates the Factor-Content theorem (Heckscher-Ohlin-Vanek theorem (1968)). This ranks each country’s relative endowments in order to paint a more comprehensive picture of trade and its subsequent direction, producing an equation such as (1.7)

(FJ¹/FW¹) > …. > (FJⁱ/FWⁱ) > s^J > …. > (FJ^m/FW^m) (1.7)

By allowing for more factors such as natural resources, land, infrastructure, and which tropical zone the country is located, the new model should prove more realistic however subsequent studies have pointed to the opposite.

While replacing constant returns to scale with increasing returns is unable to reverse the direction of trade (unless factor intensity reversal occurs) as shown by Figure 1.6, it affects other results derived from the model. Complete specialisation is more likely and factor price equalisation will not occur, instead the wage ratios will move in opposite directions.

(Figure 1.6)

Introducing barriers to trade is also unable to turnover the Heckscher-Ohlin theorem; because an import tariff solely reduces the volume of goods traded and cannot drive a country to export the commodity that intensively uses its scarce factor. This is quite a plausible result considering the effect of the factor price equalisation theorem will drive the scarce factor to lobby for protection.

(Figure 1.7)

In addition to relaxing these assumptions there are further explanations to explain the Leontief paradox and further the depth of the Heckscher-Ohlin model. These include factor intensity reversal, factor mobility, specific factors, and unbalanced trade (balance of payments) which can also overturn the H-O theorem; whilst conditions such as monopolistic competition, increasing returns, the product cycle and intra-industry trade have added further depth to the analysis and have come to represent what is now known as New Trade Theory.

With these complications in mind it is necessary to try and extract the effect of different factor endowments from all the other effects to analyse the relevance of the H-O model for policymakers. Leamer (1984) utilised regression analysis in combination with an adapted Heckscher-Ohlin-Vanek model to analyse the relationship between ten factor endowments and trade. This produced various equations showing for example an increase of capital stock by $1 million will raise net exports of capital intensive products by $16,500 and labour intensive by $1,000, confirming the H-O theorem. Whilst the equations only accounted for 50 to 60 percent of the trade patterns, a probability that “…is matched by a coin toss” (Trefler 1995, p.1029), it still shows that factor endowments are highly relevant in trade and that other factors are at work which have not as of yet been modelled. Clearly policy makers should take note of the theorem but also consider the wealth of other explanations which cloud the explanations of trade flows.

References

Keesing, D.B. (1965). “Labor Skills and International Trade: Evaluating Many Trade Flows with a Single Measuring Device.” Review of Economics and Statistics 47: pp.287-294

Leamer, E.E. (1984). “Sources of International Comparative Advantage: Theory and Evidence.” Cambridge: MIT Press.

Leontief, W.W. (1953). “Domestic Production and Foreign Trade: The American Capital Position Re-examined.” Proceedings of the American Philosophical Society 20: pp.332-349

Maskus, Keith E & Webster, Allan. (1999). “Estimating the HOV Model with Technology Differences Using Disaggregated Labor Skills for the United States and the United Kingdom,” Review of International Economics, Blackwell Publishing, vol. 7(1), pp. 8-19.

Markusen, James R. et al. (1995) “International Trade: Theory and Evidence”, McGraw Hill, p.106

Trefler, Daniel. (1993). “International Factor Price Differences: Leontief Was Right!,” Journal of Political Economy, University of Chicago Press, vol. 101(6), pages 961-87.

Trefler, Daniel. (1995). “The Case of the Missing Trade and Other Mysteries.” American Economic Review, December 1995, 85(5), pp. 1029-46.

Vanek, J. (1968). “The Factor Proportions Theory: The n-Factor Case.” Kyklos 4: pp.749-756

<!– /* Style Definitions */ p.MsoNormal, li.MsoNormal, div.MsoNormal {mso-style-parent:”"; margin:0in; margin-bottom:.0001pt; mso-pagination:widow-orphan; font-size:10.0pt; font-family:”Times New Roman”; mso-fareast-font-family:”Times New Roman”;} p.MsoFootnoteText, li.MsoFootnoteText, div.MsoFootnoteText {mso-style-noshow:yes; margin:0in; margin-bottom:.0001pt; mso-pagination:widow-orphan; font-size:10.0pt; font-family:”Times New Roman”; mso-fareast-font-family:”Times New Roman”;} p.MsoFooter, li.MsoFooter, div.MsoFooter {margin:0in; margin-bottom:.0001pt; mso-pagination:widow-orphan; tab-stops:center 3.0in right 6.0in; font-size:10.0pt; font-family:”Times New Roman”; mso-fareast-font-family:”Times New Roman”;} span.MsoFootnoteReference {mso-style-noshow:yes; vertical-align:super;} @page Section1 {size:8.5in 11.0in; margin:1.0in 1.25in 1.0in 1.25in; mso-header-margin:.5in; mso-footer-margin:.5in; mso-paper-source:0;} div.Section1 {page:Section1;} –>

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)