The Heckscher-Ohlin (HO) ModelTopic 3 (continued)

Each country will export the good that uses its abundant factor intensively.

The basic assumptions:I. Identical technologies across countriesII. Identical and homothetic tastes across countriesIII. Different factor endowmentsIV. Free trade in goods but not factorsV. No factor intensity reversals (very important assumption, why?)The underlying assumptions of a 2x2x2 model are:I. Two countries- Home and ForeignII. Two sectors- Good 1 and Good 2III. Two factors of production- Labor and CapitalIV. Home country is labor-abundant (L/K>L*/K*)V. Good 1 is labor-intensiveVI. The countries engage in free-trade

According to this set-up Home should export good 1, and Foreign should export good 2.We assume a particular case of factor endowment difference: L=L* and K*>K (i.e. the labor endowments are identical in two countries while the foreign capital endowments exceeds that at home).

Situation under Autarky: y2 F B' H C'

A slope=

0 H F y1

Autarky equilibrium is at point A where the indifference curve is tangent to home PPF (HH).The price line drawn tangent to the PPF and the indifference curve has a slope of (negative) the autarky relative price of good 1, .FF is the Foreign PPF.Let us initially suppose that pa is also the autarky equilibrium abroad.Point B' is Foreign country's production point (production must occur at the tangency between the price line with slope pa and Foreign PPF, FF).Notice that from the Rybczynski Theorem point B' must lie above and to the left of point A: the higher capital endowment abroad leads to more of good 2 and less of good 1.The price line through point B' acts like a budget constraint for the representative consumer in the foreign country, so that the consumer chooses the highest indifference curve on the price line. Since tastes are homothetic, the foreign representative consumer will demand the two goods in exactly the same proportion as the home representative consumer.In other words, the foreign consumption point must lie on the budget constraint through point B', and also on a ray from origin through point A.So the foreign consumption point is at point C', which is above and to the right of point A.Points B' and C' do not coincide.This means that the relative price pa at home cannot equal the autarky price abroad. At this price there is an excess demand for good 1 in the foreign country.This excess demand will bid up the relative price of good 1, so that the foreign autarky price must be higher than at home, pa*> pa.

Situation under Free Trade:Let:z(p)= excess demand for good 1 at prevailing price p at Home,z*(p)= excess demand for good 1 at prevailing price p at Foreign.Therefore,z(p)+ z*(p)= World excess demand at a common price p.

A free trade equilibrium occurs when world excess demand is equal to zero.

The Home autarky equilibrium satisfies z(pa)=0.But we know that z*(pa)>0.Therefore z(pa)+ z*(pa)> 0. This means that at home autarky relative price, there is an excess demand for good 1 in the world.If instead we reversed the argument in our figure and started with foreign autarky price satisfying z*( pa*)=0, then we could readily prove that z( pa*) pasuch that, z(p) + z*(p)= 0.This is the equilibrium price with free trade.

Illustration of Free Trade equilibrium: y2 y2 F slope=p B* A* H A C B C* slope=p H y1 F y1 (a) Home Country (b) Foreign Country

In panel (a), we show the equilibrium at Home. Beginning at the Home autarky point A, the relative price of good 1 rises at Home, p> pa. Now production occurs at B (where the price line through point B has a slope of p) and consumption occurs at C (where price line acts as a budget line and utility is maximized).The difference between production point B and consumption point C is made up through exporting good 1 and importing good 2 (illustrated by the dotted 'trade triangle').The trade pattern at Home establishes the HO theorem.In panel (b), the reverse pattern of trade occurs in Foreign: the relative price of good 1 falls, pa*> p. Production moves from the autarky equilibrium at point A* to B* and consumption occurs at C*. Due to this difference in production and consumption point, good 1 is imported and good 2 is exported.

Notice that the 'Trade Triangles' drawn at Home and Foreign are identical in size. This means that the exports of one country must be imports of the other.HO Model: establishes the trade pattern and has precise implications for who gains and who loses from trade.

Implications for who gains and who loses from trade:The abundant factor in each country gains from trade and the scarce factor loses.This result follows from the pattern of price change (pa*> p> pa) and the Stolper-Samuelson Theorem.With the relative price of good 1 rising at Home, the factors used intensively in that good (labor) will gain in real terms and the other factor (capital) will lose.

Notice that labor is the abundant factor at home. Labor would have been earning less in Home autarky equilibrium than in the Foreign autarky equilibrium. However, with free trade, the Home country can shift production towards the labor-intensive good and export it, thereby absorbing the abundant factor, without lowering wage.Factor prices are equalized after trade. Thus, the abundant factor, whose factor price was bid down in autarky, will gain from the opening of trade, while the scarce factor in each country loses.6