H-O theory (alternative treatment)

Of all the possible reasons for differences in relative commodity

prices and comparative advantage among nations, H-O theory
isolates the differences in relative factor abundance or factor
endowments as the basic cause of comparative advantage and
international trade.

H-O theory examines the basis for comparative advantage and

the effect trade has on factor earnings (income distribution).

Assumptions of the model:

• There are two notions (home and foreign), two goods (cloth
and food) and two factors (labour and land) in the model.
• Both nations use the same technology in the model.
• Cloth is labour intensive and food is land intensive.
• Both commodities are produced under constant return to
scale in both nations.
• There is incomplete specialization in production in both
nations.
• Tastes are same in both nations.
• There is perfect competition in both goods and factor
markets in both nations.
• There is perfect factor mobility within each nation but no
international factor mobility.
• There is no transportation cost, tariffs or other forms of trade
barriers.
• All resources are fully utilized in both nations.
• International trade between the nations is balanced.

Meanings of the assumptions:

Assumption 1 is clear; it is made in order to illustrate the model

with two dimensional graphs.
Assumption 2 means that both nation use same production
techniques. Given the same commodity prices, both nations
would use the same amount of land and labour to produce cloth
and food.

Assumption 3 means that cloth requires relatively more labour to

produce than food in both nations. More technically, land-labour
ratio is lower for cloth than food. But it does not mean that land-
labour ratio is same in home and foreign, only land-labour ratio is
lower for cloth than food in both nations.

Assumption 4 (CRS) means that doubling the inputs would double

the output in both nations.

Assumption 5 means that even with free trade both nations

continue to produce both goods. This implies that neither of the
nations is small.

Assumption 6 implies that preferences (IC curve) are identical in

both nations. When relative prices are same, both nations will
consume the same proportion of cloth and food.

Assumption 7 implies that producers and consumers are too small

to affect the prices of these commodities. Perfect competition also
implies that in the long run, prices equal to costs of production.
No economic profit in this model.

Assumption 8 means that factors are free to move across

industries. On the other hand, there is zero international factor
mobility so international differences in factor earnings would
persist in the absence of trade.

Assumption 9 means that specialization in production proceeds

until relative prices are equalized.

Assumptions 10 means that there are no unemployed resources

in either nations.
Assumption 11 implies that the total value of each nation’s
exports is equal the total value of the each nation’s imports.

Factor intensity:

For two factors (land and labour) and two commodities (food and
cloth) model, we say that cloth is labour intensive if the labour-
land ratio (LC/TC) is used in production of cloth is higher than the
labour- land (L F/TF ) ratio used in food.

For, example if 2 units of land and 2 units of labour is used to

produce 1 unit of food then TC/LC ratio is 1

For, example if 1 units of land and 4 units of labour are used to

produce 1unit of cloth then TC/LC ratio is ¼.

In this case, food is land intensive and cloth is labour intensive in

home.

Home
Land

T/L in food=1

T/L in cloth=1/4
 Labour

Foreign

Land T/L in food = 4

T/L in cloth=1

Labour

Even though food is land intensive and relation to cloth in both

nations, foreign uses a higher land-labour ratio in producing both
cloth and food.
Why foreign does uses more land intensive production
technique than home?
Answer to this question is land must be cheaper in foreign.
The next question we can ask is why is land is cheaper in
foreign?
In order to answer this question, we must define factor prices and
factor abundance.
Factor abundance:
There are two ways to define factor abundance. One way is in
terms of physical units. Another way to define factor abundance is
in terms of relative factor prices.
According to the definition in terms of physical units, foreign is
land- abundant if the ratio of total units of land to total units of
labour available in foreign is greater than home.
According to the definition of factor prices, foreign is land-
abundant if the price of land (r) to the price of labour (w) is lower
in foreign.
The relationship between two definitions is clear. The definition of
factor abundance in terms of physical units only considers the
supply of factors. The definition in terms of relative factor prices
considers both supply and demand. Since, we assumed that taste
and preferences are same, the two definitions give the same
conclusions.

Factor abundance and the shape of the PPF:

Home is labour- abundant country and food is labour intensive
good. Foreign is
land-abundant country and food is land intensive good. Since,
cloth is labour intensive good; home’s PPF relative to foreign is
shifted out more in the direction of cloth than in the direction of
food. Thus, other things equal, home tends to produce a higher
ratio of cloth to food.

Food

Foreign

Home
 Cloth

H-O theory:

A nation will export the commodity whose production requires the

intensive use of nation’s relatively abundant and cheap factor and
import the commodity whose production requires the intensive
use of the nation’s relatively scarce and expensive factors. The
central message concerning trade patterns of the H-O theory is
that countries tend to export goods whose production is intensive
in factors with which they are relatively abundantly endowed.
This is demonstrated by showing that, using the relative supply
and relative demand analysis, the country relatively abundantly
endowed with a certain factor will produce that factor more
cheaply than the other country. International trade leads to a
convergence of goods prices. Thus, the results from the Stolper-
Samuelson effect demonstrate that owners of a country’s
abundant factors gain from trade, but owners of a country’s
scarce factors lose. The extension of this result is the important
Factor Price Equalization Theorem, which states that trade in
goods leads to an equalization in the rewards to factors across
countries.
Two important results are derived using this model.
The first is known as the Rybczynski effect. Increasing the
relative supply of one factor, holding relative goods prices
constant, leads to a biased expansion of production possibilities
favoring the relative supply of the good which uses that factor
intensively.
The second key result is known as the Stolper-Samuelson
effect. Increasing the relative price of a good, holding factor
supplies constant, increases the return to the factor used
intensively in the production of that good by more than the price
increase, while lowering the return to the other factor. This result
has important income distribution implications.

References:
Salvatore, Dominick, International Economics, eighth edition, John Wiley &
Sons, Inc, 2004
Sodersten, Bo & Geoffrey reed, International economics, third edition, 1994
http://internationalecon.com/Trade/Tch40/T40-0.php