Question

a. In the Hecksher-Ohlin theory (HOT), we assume identical tastes in nations. Suppose that nation 1 is labour abundant and nation 2 is capital abundant. Good X is labour-intensive and good Y is capital-intensive in both countries. Suppose that consumers of Nation 2 have a stronger preference for X than Y while the opposite is true in Nation 1. Show that the HOT conclusions are unchanged even though tastes are different, using diagrams, assuming increasing opportunity costs in production.

b. Write clearly what the Heckscher-Ohlin theory predicts about factor prices in the trading nations after trade. How is this result affected if labour is mobile within each nation but capital is not?

Answer 1

Nation 1: labour abundant

Good X:  labour-intensive

Nation 2 : capital abundant

Good Y : capital-intensive

Hecksher-Ohlin theory states that a country which is abundant in the factor will export the commodity whose production is intensive in that factor.

It means that since nation-1 is labor abundant country and good X is labor intensive so it will export the commodity X. Similarly, nation-2 which is capital abundant country will export good Y.

HOT assumed same tastes and preferences but the same conclusion holds even if preferences are different. Production and consumption possibilities of nation-1 are shown in image below:

TT is the production possibility of the nation. The preferences are shown by indifference curves marked as IC₁ and IC₂. Initially economy sits at equilibrium e₁ producing X₁ and Y₁ quantity of two goods but its demand for good X is X_d and demand for good Y is Y_d so it needs to enter in world market. As it enters the market, price of good X starts to rise for nation-1 (because of increased market size) and the profit line shifts from (Px/Py)¹ to  (Px/Py)². At higher price of X, nation-1 produce more of X to sell it in exchange of Y.

Fitting the production and consumption possibilities of nation-2 would give us the following diagram.

PP is the production possibility of the nation-2 (it is more skewed towards good-2). As the price changes from (Px/Py)¹ to  (Px/Py)² it moves from e₁ to e₂ producing X₂ and Y₂. But the demand is X_d and Y_d. Hence we see that nation-2 still exports excess of Y (Y₂-Y_d) in exchange of good-X (X_d-X₂). So the conclusion of HOT holds even when IC of two nations are different.

Please note that i have drawn two separate diagrams for better clarity in the figure. There can be a single diagram also by superimposing second diagram on first but it makes the graph a bit complex to read.

b.) Under Hecksher-Ohlin theory, two nations keep selling and buying from each other as long as price of the two commodities in both countries is not equal. Nation-1 buys good Y from nation-2 and nation-2 buys good-X from nation-1 until Px/Py=1.

In nation-1, as more of X is produced and exported, it increases demand for labor and therefore price of the workers (wage rate) rises. Similarly, in nation-2 as more of Y is produced and exported, it increases demand for capital and therefore price of the capital (rent) rises. So in both countries factor prices follow the movement in product markets and the process goes on till the factor price also becomes equal.

If labor is mobile within each nation, then all the labor will move from nation-2 to nation-1 (as in nation-1, since more labor is demanded so they are paid better), nation-1 specialise in production of good X and nation-2 will keep producing good Y. Both the countries trade with each other to consume the good that they do not produce. Prices of both the goods converge once again.