Question

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Question

This question will ask you to use the Heckscher-Ohlin model to analyze the effect of trade

liberalization between two countries. Assume that there are two production factors (capital and

labor) and two goods (cars and clothes). Assume furthermore that the car industry is capital

intensive and that the clothing industry is labor intensive. The two countries differ in their

relative endowments of capital to labor.

a) Explain how real factor prices (the real return to capital and labor) are determined in

autarky in the two countries. How do the relative factor prices differ between the two countries

depending on their relative endowments of capital and labor?

b) Now, explain how and why trade liberalization affects real factor prices in the two countries.

c) Which country will export what good and why?

d) Owners of different factors of production can differ in attitudes to trade liberalization

depending on how much they benefit in real terms. In the two countries that you have analyzed,

who will benefit and who will lose from trade liberalization?

1

Answer 1

The Heckscher-Ohlin theorem states that a country which is capital-abundant will export the capital-intensive good. Likewise, the country which is labor-abundant will export the labor-intensive good. Each country exports that good which it produces relatively better than the other country. In this model a country's advantage in production arises solely from its relative factor abundance.

a) The real factor of prices (the real return to capital and labor) are determined by calculating the capital per worker in the aggregate. In all scenarios it is very unlikely that capital per worker would be same in both the countries. This is how the autarky in both countries are determined.Lets understand with a graph below.Let us assume that the two countries are US & France.The H-O model assumes that the two countries (US and France) have identical technologies, meaning they have the same production functions available to produce steel and clothing. The model also assumes that the aggregate preferences are the same across countries. The only difference that exists between the two countries in the model is a difference in resource endowments. We assume that the US has relatively more capital per worker in the aggregate than does France. This means that the US is capital-abundant compared to France. Similarly, France, by implication, has more workers per unit of capital in the aggregate and thus is labor-abundant compared to the US.

The difference in resource endowments is sufficient to generate different PPFs in the two countries such that equilibrium price ratios would differ in autarky. To see why, imagine first that the two countries are identical in every respect. This means they would have the same PPF (depicted as the brown PPF0 in the adjoining figure), the same set of aggregate indifference curves and the same autarky equilibrium. Given the assumption about aggregate preferences, that is U = CCCS, the indifference curve, I, will intersect the country’s PPFs at point A, where the absolute value of the slope of the tangent line (not drawn), (PC/PS), is equal to the slope of the ray from the origin through point A. The autarky price ratio in each country will be CSA/CCA.

Next suppose that labor and capital are shifted between the two countries. Suppose labor is moved from the US to France while capital is moved from France to the US. This will have two effects. First, the US will now have more capital and less labor, France will have more labor and less capital than initially. This implies that K/L> K*/L*, or that the US is capital-abundant and France is labor-abundant. Secondly, the two countries PPFs will shift. To show how, we apply the Rybczynski theorem.

The US experiences an increase in K and a decrease in L. Both changes will cause an increase in output of the good that uses capital intensively (i.e. cars) and a decrease in output of the other good (clothing). The Rybczynski theorem is derived assuming that output prices remain constant. Thus if prices did remain constant, production would shift from point A to B in the diagram and the US PPF would shift from the brown PPF0 to the PPF.

Using the new PPF we can deduce what the US production point and price ratio would be in autarky given the increase in the capital stock and decline in labor stock. Consumption could not occur at point B since, 1) the slope of the PPF at B is the same as the slope at A since the Rybczynski theorem was used to identify it, and 2) homothetic preferences implies that the indifference curve passing through A must have a steeper slope since it lies along a steeper ray from the origin.

Thus, to find the autarky production point we simply find the indifference curve which is tangent to the US PPF. This occurs at point C on the new US PPF along the original indifference curve, I. (Note: the PPF was conveniently shifted so that the same indifference curve could be used. Such an outcome is not necessary but does make the graph less cluttered.) The negative of the slope of the PPF at C is given by the ratio of quantities CS'/CC' . Since CS'/CC' > CSA/CCA, it follows that the new US price ratio will exceed the one prevailing before the capital and labor shift, i.e., PC/PS > (PC/PS)0. In other words, the autarky price of clothing is higher in the US after it experiences the inflow of capital and outflow of labor.

France experiences an increase in L and a decrease in K. These changes will cause an increase in output of the labor-intensive good (i.e. clothing) and a decrease in output of the capital-intensive good (steel). If price were to remain constant, production would shift from point A to D in the diagram and the French PPF would shift from the brown PPF0 to the PPF'.

b) This has been exlained in part a)

c) US will produce capital intensive product Cars and France will produce Clothing, because they have a cost-benefit advantage in the resptective product lines.

d) Understanding the attitudes towards trade liberalisation, in the short run the manufacturers might hold themselves from exporting the products in which they have cost advantage, but with passage of time, they would understand the optimum gain from trade liberalization. If they carry a narrow approach, then, they will have to be confined to local markets, whose competetion could be hard to sustain given low margins in comparison to the exports which would attract higher gain. This analysis would stand true for both the counties.