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home / study / business / economics / economics questions and answers / based on hecksher olin theory: a). draw and explain in a graph the free trade equilibrium for ... Question: Based on Hecksher Olin Theory: A). Draw and explain in a graph the free trade equilibrium for Hom... Based on Hecksher Olin Theory: A). Draw and explain in a graph the free trade equilibrium for Home Country (Remember PPFs? ! Make sure to clearly indicate the production point, the consumption point, and the quantity of exports and imports). B). In the graph drawn above for question (a), show the effects of a proportional increase in the endowments of labor and capital. Does welfare increase or decrease? C). One of the justifications for import-substitution strategies is the deterioration of terms of trade. This means that the price of exports falls relative to the price of imports. In the graph for question (a), draw and show a graph how this would be represented. Does welfare increase or decrease? D) Suppose that Home country is the main exporter of bananas in the world (meaning it is a large country, able to affect world prices), is it theoretically possible that economic growth decreases welfare for Home Country? Explain using a different graph from answers to questions (b) and (c). Be sure you type your answers and draw clean graphs.

Answer 1

Hecksher Olin (HO) Theory

1. The Heckscher-Ohlin model (HO) shows how trade occurs because countries that have different resources. They wanted to explain this increase in trade during the “golden age” of international trade. H-O assumed that technologies were the same across countries, but had an uneven distribution of resources.

The specific factors model is also a short run model since capital and labor could not move between industries. The HO model is a long run model because all factors of production can move between the industries.

The HO Model consists of:

• Two countries: Home and Foreign.
• Two goods: computers (good A) and shoes (goods B).
• Two factors of production say: labor (L) and capital (K).
• Resource constraint equations:
  1. Capital in each good for each country
     • K = K_C + K_S and K* = K*_C + K*_S
  2. Labor in each good for each country
     • L = L_C + L_S and L* = L*_C + L*_S

Assumptions for the HO Model

1. Both factors can move freely between industries.
   1. R and W must be the same in both industries.
2. Shoe production is labor-intensive; it requires more labor per unit of capital to produce shoes than computers, so that L_S/K_S > L_C/K_C.
   1. This means that computer production is capital-intensive.
   2. Figure 1 shows relative demand curves for labor in each industry.

Figure 1: Labor Intensity of Each Industry The demand for labor relative to capital is assumed to be higher in shoes than in computers, L_S/K_S>L_C/K_C. These two curves slope down just like regular demand curves, but in this case, they are relative demand curves for labor (that is, demand for labor divided by demand for capital).

1. Foreign is labor abundant. Equivalently, Home is capital abundant
   1. L*/K* > L/K and K/L > K*/L*
   2. Here, we do not consider why the amount of resources differs across countries. Take as given.
2. The final outputs, shoes and computers, can be traded freely, without restrictions, between nations, but labor and capital do not move between countries.
3. The technologies used to produce the two goods are identical across the countries.
   1. This is opposite of the assumption in the Ricardian model.
4. Consumer tastes are the same across countries, and preferences for computers and shoes do not vary with a country's level of income.

HO Model Free Trade Equilibrium

1. Three steps to finding free trade equilibrium
   1. Trace out the Home export supply of computers.
   2. Trace out the Foreign import demand for computers.
   3. Put together the export supply and the import demand to determine equilibrium relative price of computers.
2. Home Equilibrium with Free Trade (Figure 2)
   1. The Home PPF will show a free trade or world relative price of computers that is higher than the no-trade Home relative price.
   2. They will produce more computers and fewer shoes.
      1. Home specializes in and exports computers.

1. We can use the Home trade information to graph the exports of computers against the relative price.
2. Trace out the quantity of exports at each relative price.
3. This gives the Home export supply curve for computers.
4. It is upward-sloping since at higher relative prices, Home is willing to specialize further in computers and export more of them.

As we can notice from the graph that the welfare increases for the home country seeing the intensive employment opportunity generation as a result of labor utilization for production of export goods.

• The equilibrium free trade price is determined by the intersection of the Home export supply curve and the foreign import demand curve: Point D (Figure 3).
• At that relative price, the quantity that Home wants to export equals the amount that Foreign wants to import.

This is a free-trade equilibrium since there is no reason for the relative price to change.