Question

Explain the H-O (standard model) of international trade. Using the Stolper-Samuelson Theorem, explain what is expected to happen to factor returns in the US following an expansion of international trade. What implications does this have for inequality in the US?

Answer 1

The Heckscher-Ohlin Model (H-O model) of international trade is used to explain trade between two countries or regions which have varying factor endowments and factor prices. The model emphasizes on the exportation of goods which require the factors of production which the country has in abundance and the importation of goods which it cannot produce as efficiently. For example, a country which is rich in capital will export capital intensive goods whereas the ones which have abundant labour will export labour intensive goods.

It is a two-by-two-by-two model, i.e., there are 2 countries, 2 commodities and 2 factors of production and has a number of assumptions involved.

1. Perfect competition in both commodity and factor market

2. Full employment of resources

3. Qualitative homogeneity of factor endowments

4. Perfect mobility of factors within each region

5. No transportation costs

6. Free and unrestricted trade

7. Constant returns to scale

8. No change in consumer preference

Given these assumptions, the model asserts that the cause of international trade is the result of differences in factor endowments between the 2 countries which causes differences in relative demand and supply of factors which in turn causes difference in the relative commodity prices. Thus commodities which use large quantities of scarce resources are imported whereas those which use factors that are in abundance are exported. It demonstrates that free trade will increase the aggregate efficiency of the countries. The change in price will shift the production pattern of both countries. Each country will produce more of its export good and less of its import good.

• Stopler-Samuelson Theorem

The theorem describes the relation between change in prices of goods and change in factor prices. It states that if the price of a capital intensive good increases the price of capital will rise while the wage rate paid to the labour will decrease. Prices change in a country when liberalization of trade occurs. Trade expansion will cause the real returns of the relatively abundant factor to rise whereas that of the relatively scarce factor will decrease. Thus with US being a capital abundant country as compared to labour, trade expansion will lead to increase in gains by the capital owners of the country whereas the workers will experience a decline in their wage rate.

This can be further explained in detail as follows,

When a country which has abundant capital compared to labour, moves to free trade, the prices of its exported goods(Capital intensive) rises while that of its imported goods(Labor intensive) fall. This causes increased production in the export industry seeking higher profits and decrease in production in the import industry. Capital and labor will be laid off in the import industry whereas its demand will increase in the export industry. Now, as the country's abundant factor is capital the export industry which is capital intensive, will need more capital per worker than the ratio of factors that the import industry is laying off. Thus the demand for capital will increase which will lead to an increase in its price whereas the supply of labor will increase causing its price to fall.