Question

Suppose you are modeling a two country, two good world within the H-O framework where the two countries are the United States and Canada and the two goods are computers and lumber. Further assume that the United States is capital abundant, and computers are capital-intensive. Using the three theorems of the H-O model, explain in words and appropriate diagrams/equations what happens in BOTH the United States and Canada when trade is allowed.

Answer 1

Hecksher Ohlin Theory :

Introduction

As per it the determination of pattern of production , specializations and trade depends upon the relative availablity of factor endowments and factor prices i.e. the nation like USA which are capital rich will import labor intensive goods(lumber) from Canada a nation which is labor rich and Canada will import capital intensive good(computer).

Assumption

• 2×2×2 model i.e. two nations ,two factor of production and two goods
• Perfect competition
• Factors of production are mobile in nation but not internationally
• Free and unrestricted trade will happen between two
• Constant return to scale is applicable

Explaination

( i ) FACTOR ABUNDANCE IN TERMS OF PRICE :

• Here as USA is capital intensive ( so price of capital over price of labor ) of A is less than of B (price of capital over price of labor ) making B a labor intensive nation , so USA will produce capital intensive (computers) and import labour intensive (lumber) from Canada and visa versa.
• YY is isoquant for computer for USA (nation A) with factor price line AA1 and XX is isoquant for lumber for Canada (nation B) with factor price line BB3.
• USA produce more of capital at OC and less labor at OG to produce computer and same goes for OD and OH thereafter with more capital and less labor it can produce computer. Hence it is capital intensive
• Canada will also produce another factor price line B1B2 , which is parallel to it , herein OJ of labor and OF of capital is needed to produce lumber . Hence it is labor intensive

( ii ) FACTOR ABUNDANCE IN PHYSICAL TERMS:

• Here in physical terms the capital abundant nation will have higher proportion of capital than other i.e. proportion of capital to labor in USA > proportion of capital to labor in Canada
• ST and KR are factor price line
• AA1 and BB1 are factor price line
• If both produce same proportion it is on OR line
• If variable than for USA it is at E and for Canada it is at F
• Slope of ST is steeper than slope of KR

( iii ) NEED TO HAVE SAME TASTE AND PREFERANCE

• USA's production possibility curve is AA1 and Canada's production possibility curve is BB1
• If so happens than only tt line will exist and trade is possible i.e. factor price line and both would trade if price of computer over price of lumber of USA = price of computer over price of lumber in Canada
• CI - community indifference curve ; it will be common if taste and preferences are same making it intersect at E , USA will export ST and import TE and Canada will export KR and import EK

Conclusion

So with three i.e. factor abundance in price, factor abundance in phsyical terms and Community indifference curve the trade between USA and Canada will happen so as explained above

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