Heckscher-Ohlin Model - Report Example

International Trade Table of Contents International Trade Table of Contents 2 Introduction 3 Outline of the Heckscher-Ohlin model of International trade 3 Heckscher-Ohlin Model: Inequality between Developed and Developing Countries 6 Validity of Heckscher Ohlin Theory 7 Conclusion 7 References 8 Introduction This project aims to discuss about the Heckscher-Ohlin Model and its predictions for inequality between the developed and developing countries. It also discusses about the validity of the model. This model assumes the existence of two countries producing two commodities using two factors of production. The aim of this project is to predict the trade pattern of commodities between two countries. This trade is based on the factor endowment difference between two countries. Firstly this project aims to discuss the model in length, then it goes on to discuss how this model leads to widening the gap between the developed and developing nations of the world. Finally, it comments on the validity of the model and its implications in today’s world. Outline of the Heckscher-Ohlin model of International trade Before discussing the content of the model, it is important to know the assumptionson which the model is based. As already discussed this model assumes that there are two countries producing two goods, having two homogeneous factors of production. It is also assumed that technologies prevailing in the two countries are identical. Production of the two commodities abides by the conditions of constant returns to scale. One of the two commodities uses one of the two factors of production more intensively in comparison to the other. The existence of perfect competition is assumed in both commodities and factor markets. Factor mobility prevails within the same country but not among different countries. Tastes are also considered to be similar between the two countries. Finally, it is assumed that there are no trade barriers and no costs incurred for transportation. The Heckscher-Ohlin theory states that a capital abundant country exports commodities which are capital intensive and the country which is labour abundant exports commodities exports labour intensive commodities. This model has been explained with the help of a diagram. Figure 1: Diagrammatical Representation of Heckscher-Ohlin Model (Source: Feenstra, 2004, p.33) The country which is exporting is referred as the foreign country and the country importing is referred to as the home country. It is assumed that the home country and the foreign country is exporting commodity 1 and 2 respectively. Then, according to the assumption, the home country exports good 1, while the good 2 is exported by the foreign country. To prove this, a particular case of factor endowment difference is considered, L/K > L*/K*, and it is also assumed that labour endowments in both countries remain identical. Thus, L = L*. The capital endowment in the foreign country exceeds that in the home country, i.e. K > K*. In order to determine the trade pattern existing between the two countries, it is important to establish the relative product price existing in the two countries in autarky, or when there is absence of any trade. The pattern of prices during autarky is then used to predict the pattern of trade. Each country will export that good whose price during free trade is more than its price during autarky. Similarly, the country will import that commodity whose price during free trade is less than its price during autarky. In the figure, the autarky equilibrium is explained for the home country at point A. Demand of consumers is represented with the help of a demand curve and this consumer is assumed to have homothetic tastes (Feenstra, 2004, p.32). The autarky equilibrium is established at point A, where the indifference curve gets tangent to the production possibility frontier for the home country. The price line which is tangent to Production Possibility Frontier (PPF) and also the indifference curve has a negative slope, i.e. pa = (p1a / p2a). Now, the PPF of the foreign country is considered and is shown outside PPF of the home country in figure 1. To determine the foreign autarky equilibrium, pa is assumed to be the autarky equilibrium price in the foreign country, and is seen if the assumption gives rise to any contradiction. In the figure, if pa is said to be the price in the absence of trade in abroad, then production is supposed to prevail at the point of tangency between the PPF for the foreign country and the price line which has a slope of pa. According to ‘Rybczynski theorem’ B’ is supposed to be positioned at the left side and above point A. A higher endowment of capital in the foreign country leads to more production of commodity 2 than commodity 1. Price line going through the point B’ behaves like a constraint for budget for the consumer for the country abroad, so that he is able to choose the highest level indifference curve on the price line. Tastes are assumed to be homothetic. Thus, consumers in the foreign country will demand for the two goods in the same proportion as that demanded by the home consumer. Thus the consumption point in the foreign country lies on the budget line going through B’. Simultaneously it must also lie on the line which starts from the origin and passes through A. Thus, foreign consumption must lie on the point C’. Point C’ lies above and to the right side of point A. This is where the contradiction arise because B’ and C’ does not coincide on the same point. Thus, it is concluded that pa which is the relative price in the home country cannot be equal to the price in the foreign country in the absence of trade. In fact at this level of price, there is excess demand in the foreign country for commodity 1. This excess demand prevailing in the foreign country causes the price of good 1 to rise, so that autarky price in the foreign country is more than that in the home country, i.e. pa* > pa. In order to establish the equilibrium price at free trade, it is assumed that z(p) is the excess demand for the first commodity and z(p*) is the excess demand for commodity 1 in the foreign country. Excess demand in the world is z(p) + z(p*). Equilibrium at free trade occurs when this excess demand becomes zero. Heckscher-Ohlin Model: Inequality between Developed and Developing Countries The HO model states that nations export those commodities which use the factors of production which are relatively abundant in the country. It imports those commodities which use those factors intensively that are scarce. As the exports sector expands trade leads to the increase in demand for the factors which are abundant. It also leads to the reduction in demand of the factor which is scarce because of less number of sectors which are import competing. Developing countries are characterised by abundant unskilled labour and scarce skilled labour. Trade in these countries tend to raise wages for unskilled labour and lower wages for skilled wages in order to narrow the gap between the two (Wood, n.d. p.2). Validity of Heckscher Ohlin Theory It is said that this theory remains excessively restricted to number of assumptions. The theory is presented in the form of a statement about the “commodity composition of trade”, that makes it valid only while considering two factors of production, two commodities and a two country model. Another version of this theorem has been developed considering more than two commodities, factors and countries. In doing so, other restrictive assumptions had to be considered. The general version developed was similar to the extension of the theory of comparative advantage in the context of correlation between trade and autarky prices. In the general model, impediments of trade, like tariffs and taxes on taxes are allowed, but it has ignored costs of transport. Because of the existence of unequal prices of factors across the world, it is difficult to infer the factor content for trade. Consequently it has led to the development of a number of definitions. Conclusion Thus, it is clear that a capital abundant country exports commodities which are capital intensive and a labour abundant exports commodities which are labour intensive. The project gives a detailed explanation of how the Heckscher Ohlin theory was developed and how it functions. But the theory has number of limitations. It takes too many assumptions into account and becomes extremely weak when these assumptions are made released. A more general theory has also been developed which has been discussed in the project. Finally, it is concluded that the model leads to inequality between developed and developing countries resulting from wage differences. It comes to the conclusion that openness in trade leads to widening the gap between the developed and developing countries. References Deardorff, A. V. 1982. The General Validity of the Heckscher-Ohlin Theorem. Americal Economic Association. [Online]. Available at: http://www.jstor.org/pss/1810010 [Accessed on August 17, 2010] Feenstra, R. C. 2004. Advanced international trade: theory and evidence. Princeton University Press. Woods, A. No Date. Heckscher Ohlin Theory. Openness and Wage Inequality in Developing Countries: Latin American Challenge to East Asian Conventional Wisdom. [Pdf]. Available at: https://www.hec.unil.ch/docs/files/40/285/openness_and_wage_inequality_in_developing_countries.pdf [Accessed on August 17, 2010]. Read More