3.

Heckscher-Ohlin Mode of Trade

Heckscher-Ohlin Model

1. Setup
2. Autarky Equilibrium
3. Free Trade Equilibrium
4. The Heckscher-Ohlin Theorem
5. The Factor-Price-Equalization Theorem
6. The Stolper-Samuelson Theorem
7. The Rybczynski Theorem

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 3.Heckscher-Ohlin Mode of Trade

Problems with Ricardian model:

1. It predicts complete specialization
2. It predicts that all workers will gain from free trade. In
real life some workers oppose free trade. (E.g. U.S. steel
workers oppose free trade with China)

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Heckscher-Ohlin Model:
• 2 factors: capital (K) and labour (L) => concave
production frontier => no complete specialization, in
equilibrium each country produces both goods
• Comparative advantage is based on national differences
in factor endowments. Countries have different factors
endowments (e.g. capital, labour (skilled or unskilled),
land etc.) Differences in relative factor endowments
result in differences in autarky prices. E.g. countries that
have relatively abundant supplies of agricultural land
(like Canada, USA) have cheaper autarky prices of
agricultural products and become exporters of
agricultural products.
• The model predicts that trade leads to redistribution of
income between capital and labour => explains
opposition to trade of some factors of production
• This model is favoured by economists and is
supported by the real world data. There is a great deal of
evidence that differences in factor endowments are
important in explaining trade patterns.

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1. Setup
2 goods: X,Y
2 factors: K,L, capital gets rent r, labour gets wage w
2 countries: H,F

Assumptions
1. Identical CRS production functions in H and F
2. Kh, Lh, Kf, Lf - fixed factor endowments
• factors are perfectly mobile within each country
between X and Y sectors;
• factors are immobile between countries.
3. H, F differ in relative factor endowments. (This will give
rise to price differences in H and F.)
4. Consumers in H, F have identical, homogenous
preferences
5. No distortions (tariffs etc.)

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Definition
Factor Endowments
If capital- labor ratio in country H is greater than it is in
Kf
country F ( K h
> ), then country H is relatively capital-
Lh Lf

abundant and labour-scarce, while country F is relatively

labour-abundant and capital-scarce.
Example
K stock L K
L
($b.) (m)
($)
Brazil 507 53 9, 566
US 3,696 116 32,421
Switzerland 120 3 40,000
=> U.S. is capital-abundant relative to Brazil, but capital-
scarce relative to Switzerland.

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K A. Factor Endowments Graph

H is capital-abundant, F is labour-abundant
Eh
Kh

slope=home capital-labour ratio

Ef
Kf

slope=foreign capital-labour ratio

L
Lh Lf

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Definition
Factor Intensities
Good Y is relatively capital-intensive and good X is
relatively labour-intensive if the capital-labour ratio used in
Ky Kx
production of good Y is higher: >
Ly Lx

Example
K $m L thousands K
,$
L

Petroleum 27,005 95 284,263

Footwear 514 107 4,804

Take some price ratio w/r. Producers minimize costs =>

isoquant is tangent to w/r. For any price ratio, at optimum
K K
( ) y > ( )x => good Y is relatively capital-intensive, X is
L L

relatively labour-intensive.

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K B. Factor Intensities Graph

Y is capital-intensive, X is labour-intensive

Ky

slope=Y’s capital-labour intensity

Kx
X
slope=X’s capital-labour intensity
w
−
r
L
Ly Lx

Assume:
1. Country H is relatively K-abundant, county F is
relatively L-abundant
2. Good Y is K-intensive, X is L-intensive
Yh , X h , Y f , X f - maximum amounts of goods X, Y that H, F

can produce (i.e. if all resources are devoted to production

of one good)

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Result

Yh Yf
>
Xh X f

I.e. capital-abundant country can produce relatively more

of capital-intensive commodity.

Can be shown in 2 steps:

Step 1. Assume that H, F are similar in size, H is capital-

abundant, F is labour-abundant:

K A. Factor Endowments Graph,

Yh Isoquants for Y and X

Eh
Kh

Yf
Kf

Ef
Xh Xf

L
Lh Lf

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Commodity Space, Home and Foreign PPFs

Y

Yh

Home PPF

Yf

Foreign PPF

X
Xh Xf

Yh Yf
Yh > Y f ; X h < X f =>
>
Xh X f

Yh Y f
Step 2. CRS technology => X , X are independent of
h f

sizes of the countries.

Let X = f x ( K , L ), Y = f y ( K , L ) be maximum amounts

of goods X and Y that can be produced.

A country grows and now has 3 times more capital and
labour. The outputs of X and Y are:

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f x (3K ,3L ) = 3 f x ( K , L ) = 3 X

f y (3K ,3L ) = 3 f y ( K , L ) = 3Y

X
before growth, the ratio was Y ; after growth, the ratio

3X X
stays the same: 3Y = Y .

Commodity Space, PPFs

Y

Home
Yh PPF

2Y f

Yf

1
Yh
3
Foreign PPF

1 Xh Xf 2X f X
Xh
3

=> Independently of country sizes, PPF of a relatively

capital-abundant country will be more stretched along the
K-intensive axis.

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2. Autarky Equilibrium

Assume: H is a capital-abundant country and Y is a

capital-intensive good.

Autarky
Y

Yh
Ah

Home u ah
PPF

Yf Af P
h
u af

P
f

Foreign PPF

X
Xh Xf

Note: Identical homogenous preferences => H and F have

parallel indifference curves. Home and foreign production
and consumption in autarky are at Ah and Af.

Tangency between the PPF and indifference curve

determines autarky price ratios:

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Pxh Pxf
>
Pyh Pyf

=> Capital-intensive good Y is relatively cheaper in capital-

abundant country H, while labour-intensive good is cheaper
in labour-abundant country F.

3. Free Trade Equilibrium

If countries open to trade, H observes relatively cheaper X

abroad, F observe relatively cheaper Y abroad =>

H exports Y (k-intensive good) and imports X, F exports X

(l-intensive good) and imports Y. H produces more Y and
less X, and F produces less Y and more X.

Note: There is no complete specialization in this model,

both countries keep producing both goods after trade.

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Move from Autarky to Free Trade

Y

Qh*
Yh

Ah
C h*
u h*

Yf C *f
u hA
u *f
Af u Af P*
Q *f

P*
X
Xh Xf

• Trade equalizes prices in 2 countries

• H, F produce both goods
• Both H and F gain from trade.

4. The Heckscher-Ohlin Theorem

Theorem
The Heckscher-Ohlin Theorem
A country will export the commodity that intensively uses
its relatively abundant factor

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Note: Empirically HO theorem applies better to countries

with large differences in relative endowments (e.g. USA –
Mexico trade). This trade model predicts inter-industry
trade.

Free Trade, Trade Triangles

Y

Qh*

H’s exports of Y

= C h*

*
u h*
C f
F’s imports of Y
u *f
P*
Q *f

P*
X

H’s imports of X =F’s exports of X

World price P* adjusts to keep trade balanced: H’s imports

of X= F’s exports of X and H’s exports of Y= F’s imports
of Y.

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5. The Factor-Price-Equalization Theorem

After countries open to trade each country observes higher

relative price for its exports:

H: observes higher relative price of Y, exports Y (k-

intensive good), resources are reallocated from sector X to
sector Y => demand for capital, demand for labour =>
r and w => w/r

F: observes higher relative price of X, exports X (l-

intensive good), resources are reallocated from sector Y to
sector X => demand for labour, demand for capital =>
w and r => w/r

there is a relationship between prices of goods and factor

prices:
w P Px w
= G ( x ) , such that
r Py Py => r .

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Note: technology in H, F is identical =>function G(.) is

identical in H,F.
w w
(
1. In autarky: Ph>Pf => r h) > ( ) f i.e. labour is
r
relatively cheaper in labour-abundant country, capital is
relatively cheaper in capital-abundant country.
w w
(
2. Trade: Ph=Pf =P* => r h ) = ( )f
r
Theorem
The Factor-Price Equalization Theorem
Under identical CRS production technologies free trade in
commodities will equalize relative factor prices through
equalization of relative commodity prices so long as both
countries produce both goods.

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2 fundamental relationships:

• Change in price P (e.g. change from autarky price

Pa to free trade price P*) => change in factor rewards
w,r (The Stolper-Samuelson Theorem)
• Change in endowments K , L => change in outputs of
X,Y (The Rybczynski Theorem)

6. The Stolper-Samuelson Theorem

Theorem
The Stolper-Samuelson Theorem
If there are constant returns to scale and if both goods
continue to be produced, a relative increase in the price of a
commodity will increase the real return to the factor used
intensively in that industry and reduce the real return to the
other factor.

Assume X is a labour-intensive good. If Px/Py increases,

real returns to workers will increase, while real returns to
capital owners will fall.
Proof:

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w w r r
Real wages: P , P , P , P
x y x y

w w
,
Px Py
Px
SS: Py => r r
,
Px Py

Note: in equilibrium, factor price=value of marginal

product

Recall labour market equilibrium conditions:

Sector X: Sector Y:

w = Px MPLx w = Py MPL y
r = Px MPK x r = Py MPK y

Real wages:

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w w
= MPLx = MPLy
Px Py

r r
= MPK x ; = MPK y
Px Py

Px
We have to show that change in relative prices P affects
y

Px
marginal products in X and Y sectors, so that Py =>

MPL in both sectors, and MPK in both sectors.

2 steps (no rigorous proof required)
Px
Step 1. Py => output of X => demand for labour

increases relative to demand for capital because X is a

labour-intensive good => w/r – labour becomes relatively
more expensive => K/L ratio both in production of X and
Y (producers substitute away from relatively more
expensive input).

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K w B. Factor Intensities Graph: change in w/r

− ’
r
Y is capital-intensive, X is labour-intensive
w
− ’
r
Ky

slope=Y’s capital-labour intensity

Kx
X
slope=X’s capital-labour intensity
w
−
r
L
Ly Lx

(note: homothetic production function: same K/L ratio for

all levels of Y (or X) for any w/r)

Step 2. K/L => MPL, MPK (because of law of

diminishing returns)

Recall Properties of Production Function:

• Law of Diminishing Marginal Product. If use of L in

the production of X is increasing, total product of

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labour is increasing at a decreasing rate.

X TPx ( Lx , K 2 )

C
TPx ( Lx , K1 )
B

L1 L2
Lx

MPLx ( Lx , K 2 )
- slope of TP curve
A

MPLx ( Lx , K1 )
B
- slope of TP curve

L1 L2 Lx

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1. Increase labour from L1 to L2 keeping capital fixed at

K1 , TPL increases, MPL falls. (Movement from A
to B on Total Product or Marginal Product graph).

2. Keep labour fixed at L1, increase K 2 , TPL

increases, MPL increases. (Movement from A to C on
Total Product or Marginal Product graph).
K K K
Generally, MPL = f ( ) MPL ;
L : L L

MPL

K K K
Similarly, MPK = f ( ): MPK x ;
L L L

MPK

E.g. if K by 15%, and L by 10% MPL because

capital-labour ratio goes up, but MPK falls.

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Application of Stolper-Samuelson Theorem:

E.g. labour-abundant country F (relatively cheap X) enters
free trade with capital abundant country H (relatively cheap
Y). As a result of trade, within each country prices change
to the world price P*.
Px
A
F: P*>Ph => Py => w/r , workers gain from trade in

real terms, capital-owners lose.

Px
A
H: P*<Pf => Py => w/r, capital-owners gain, workers

lose.
Country exports services of the relatively-abundant factor
=> increase demand for abundant factor => higher return to
abundant factor. Relatively abundant factor gains from
trade, relatively scarce factor loses from trade. Trade in HO
model has redistributional effect: there is aggregate gain
from trade, but the gain is incurred by the abundant factor
only, while the scarce factor incurs loses. (I.e. abundant
factor gains more that average, while scarce factor loses.)
E.g. unskilled labour is relatively scarce in the U.S. =>

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workers protest free trade with developing countries and

demand protection.

7. The Rybczynski Theorem

The Rybczynski Theorem

If relative commodity prices are constant and if both
commodities continue to be produced, an increase in a
supply of a factor will lead to an increase in output of the
commodity using that factor intensively, and a decrease in
the output of the other commodity

E.g. immigration => increase in L - one may expect that

outputs of X and Y will both increase. NO! Output of X
will increase, output of Y will decrease. If home country
increases its capital stock, it will produce more of good Y
and less of good X.

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Y Growth in Labour Endowment (X is labour-intensive good)

Output expansion

P
P
X

X X

The theorem is important as it predicts the impact of

economic growth on trade. The way in which country
growth has an impact on its production and trade mixes.
Countries with low saving rates but high population growth
would tend to produce goods and export goods with high
labour contents. Countries with high saving and investment
rates will produce and export more capital-intensive goods.

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