EC 380: Lecture 4

.title[
# EC 380: Lecture 4
]
.subtitle[
## Trade Theory: Heckscher-Ohlin (HO) Model
]
.author[
### Philip Economides
]
.date[
### Winter 2024
]

---

# Prologue

---

# To Recap

### Last Time

* Countries with no absolute advantage in production can still trade!

* Since then, the .hi-pink[internet] and subsequent .hi-pink[information age] have largely narrowed differences in technology

* .hi-pink[What else helps us understand what drives our need to trade goods?]

### Today

.hi-slate[Hechscher-Ohlin Model] suggests differences in factor endowments can explain trade patterns

---

# Hechscher-Ohlin Model

<br>

We will go with our own version of the model.

* Two countries, Home and Foreign
* Two goods, steel and cloth
* .hi-pink[Two] factors of production, labor and .hi-pink[capital]

Suppose in our case the home country ends up exporting apple pies and importing potatoes.

---

# Hechscher-Ohlin Model

__Key terms:__

.hi-slate[Factor abundance]: Relative measure, where if particular factor `$x$` represents a large share of total factors, country is `$x$`-factor abundant.

.hi-slate[Factor scarcity]: Country has less of a particular factor relative to other factors or in comparison to another country.

The .hi-pink[capital-labor ratio] is a comment tool of comparison for assigning countries into resource endowment groups.

The higher `$K/L$` is for a given country, relative to others, the more capital-abundant it is.

---

# Hechscher-Ohlin Model

<br>

<table class="table" style="margin-left: auto; margin-right: auto;">
 <thead>
  <tr>
   <th style="text-align:left;">  </th>
   <th style="text-align:left;"> Ireland </th>
   <th style="text-align:left;"> United Kingdom </th>
  </tr>
 </thead>
<tbody>
  <tr>
   <td style="text-align:left;"> Capital </td>
   <td style="text-align:left;"> 90 Tractors </td>
   <td style="text-align:left;"> 150 Tractors </td>
  </tr>
  <tr>
   <td style="text-align:left;"> Labor </td>
   <td style="text-align:left;"> 300 Farmers </td>
   <td style="text-align:left;"> 400 Farmers </td>
  </tr>
</tbody>
</table>

<br>

`$$\frac{K_{IRL}}{L_{IRL}} = 0.3, \ \ \ \frac{K_{UK}}{L_{UK}} = 0.375$$`

---

# Hechscher-Ohlin Model

### Production Costs

<br>

The ratio between capital and labor implies .hi-pink[abundancy]. Countries where a given factor is relatively .hi-pink[more abundant] exhibit .hi-pink[lower input prices] per unit of the factor.

The labor-abundant country finds labor to be relatively cheaper, per unit, than the capital-abundant country.

HO: Labor-abundant country has a .hi-pink[comparative advantage] due to its edge the cost of production of .hi-pink[labor-intensive goods].

---

# Hechscher-Ohlin Model

### Production Costs

<br>

Since the US is .hi-pink[capital-abundant], it faces relatively cheaper capital and faces a lower opportunity cost in production that uses relatively more capital.

This may explain US trade patterns in which .hi-pink[capital-intensive] exports of jet engines and agricultural products dominate its goods outflows.

---

# Gains from Trade

<br>

Ricardian model assumed a single factor `$\implies$` all countries face same trade-off regardless of input levels.

HO model now considers combinations of factors, where some specific combination of two is most productive.

Production possibilities frontier (PPF) will be curved instead of straight.

---

# New PPF

---

# New PPF

<br>

As you can see, adjustments at the tailend of these frontiers require a disproportionately large exchange on equipment.

Opportunity costs are .hi-pink[rising] for each type of production.

Each unit increase in the labor-good leads to an increasingly sizeable loss of the other unit.

As you reallocate resources from a capital-intensive good to labor-intensive, you need greater amounts of factors due to factor combinations being misaligned.

---

# Gains from Trade: Autarky

In absense of trade, Home consumes exactly what it produces.

---

# Gains from Trade: Free Trade

<br>

Upon opening up trade and facing no trade costs, the world PPF is now the item of material interest.

The previous relative prices of goods changes to a .hi-pink[world relative price]. This identifies the slope of the CPC described in IE Ch. 4.2.2.

Given that this line is not tangental to the production possibility frontier, there are other bundles of goods that reach higher indifference curves `$U_i$`.

In our case, Home reaches `$U_2$` by reallocating production away from textiles and towards manufacturing, given that Home is a capital intensive nation.

---

# Gains from Trade: Free Trade

---

# Gains from Trade: Free Trade

---

# Gains from Trade: Free Trade

---

# Gains from Trade: Free Trade

---

# Gains from Trade: Free Trade

<br>

Since we are trading at .hi-pink[world price level], we can reach .hi-pink[higher] indifference curves.

We .hi-pink[produce at B] and .hi-pink[consume at C] at Home country.

Therefore if we produce more .hi-pink[manufacuturing output] than we consumer, we must be .hi-pink[exporting] a subset of these goods (difference between B outcome and C outcome).

In contrast, we produce less .hi-pink[textiles] than we consume, suggesting that Home is .hi-pink[importing] the difference.

---

# Comparing to Ricardian Model

We must produce where the opportunity cost of producing a manufactured good is equal to the relative world price slope (CPC).

Our notion of trade gains are pretty similar to Ricardian views, but specialization is not complete due to .hi-pink[diminishing marginal productivty] associated with each factor.

.hi-pink[Diminishing marginal productivty]: Holding your other factor fixed, the marginal unit increase of a given factor yields increasingly smaller contributions to overall output.

---

# Comparing to Ricardian Model

Imagine having one shovel to share between 5 workers. Sure they can exchange the shovel whenever they get tired, but including 10 more is going to make very little difference to total work output.

---

# Trade & Income Distribution

In .hi-pink[Ricardian model] we ruled out harmful effects and suggest everyone benefits in society.

Reallocated workers simply left and shrinking industry for an expanding one and were able to exchange their unchanged labor supply for a .hi-pink[larger bundle of goods].

The .hi-pink[HO model] takes a more moderate view

Rather than capital and labor, consider two labor sectors

* Skilled

* Unskilled

Industries require different combinations of skilled and unskilled labor

---

# Heterogenous Income Effects

<br>

We will go into this further later into the course but for now keep in mind that trade openness can have heterogeneous effects depending on which part of the skill bracket a laborer belongs to.

It can be shown that a systematic relationship exists between endowments of factors for a country and who ends up being these winners and losers.

I'll show  you a .hi-pink[theoretical argument] for how this can occur. Later we'll examine .hi-pink[empirical evidence], based on applied econometric analysis.

---

# Stolper-Samuelson Theorem

<br>

Explains theoretical outcomes of assymetric factor outcomes.

* Income depends on input supplied to value of final product

* Wages will vary based on their skill level

* Labor input earnings (wages) demand on their demand and supply

.hi-pink[Derived demand]: Demand for a good or service that is derived from demand for something else (e.g. demand for labor is based on demand for goods and services).

---

# Stolper-Samuelson Theorem

<br>

Under high output demand, price is high and inputs used to produce benefit by receiving greater returns on their contribution.

Any change that impacts prices will have direct impacts on outcomes.

Open trade causes the .hi-pink[export good price] to rise and .hi-pink[import good price] to fall. Demand for each factor readjusts, leading to change in returns to each factor.

Resources leave sector of imported good and enter sector of exported good, which cause changes in demand for each input in Ricardian model.

---

# Stolper-Samuelson Theorem

<br>

If manufacturing good is the export, demand for capital factor rises and demand for labor factor falls.

This implies income for actors used intensively for the import sector fall and rises for the intensive factor of the export sector.

.hi-pink[Stopler-Samuelson Theorem suggests that increase in price of good raises income earned by factors intensively used in its production. Fall in price of goods lowers income of factors used intensively.]

---

# Stolper-Samuelson Theorem

<br>

According to this __theory__, a country with a capital-intensive presence (e.g. USA) will shift away from labor demand.

Capital owners will benefit from trade. Laborers will lose out.

Read further into the .hi-pink[magnification effect]. This may come up in the future.

---

# To Recap

* Countries with no absolute advantage in production can still trade in both Ricardian and HO models

* In HO case, advantages are driven by abundancies in different factors which vary across countries

* While Ricardian trade openness is a broad gain for everyone, HO highlights a .hi-pink[reallocation] of resources towards specific industries that may disadvantage the factor belonging predominantly to the now partially import-reliant sector.

### Next Class

* Specific Factors model, Model Empirics & Extensions

---