The Heckscher-Ohlin (HO) Model

Topic 3 (continued)
Each country will export the good that uses its abundant
factor intensively.

The basic assumptions:

I.
II.
III.
IV.
V.

Identical technologies across countries

Identical and homothetic tastes across countries
Different factor endowments
Free trade in goods but not factors
No factor intensity reversals (very important assumption,
why?)

The underlying assumptions of a 2x2x2 model are:

I.
II.
III.
IV.
V.
VI.

Two countries- Home and Foreign

Two sectors- Good 1 and Good 2
Two factors of production- Labor and Capital
Home country is labor-abundant (L/K>L*/K*)
Good 1 is labor-intensive
The countries engage in free-trade

According to this set-up Home should export good 1, and Foreign

should export good 2.
We assume a particular case of factor endowment difference:
L=L* and K*>K (i.e. the labor endowments are identical in two
countries while the foreign capital endowments exceeds that at
home).

Situation under Autarky:

y2
F
B'
H

C'

A
pa1
slope= p = pa2
a

y1

Autarky equilibrium is at point A where the indifference curve is

tangent to home PPF (HH).
The price line drawn tangent to the PPF and the indifference curve
has a slope of (negative) the autarky relative price of good 1,
pa1
p= a
p2
a

FF is the Foreign PPF.

Let us initially suppose that pa is also the autarky equilibrium
abroad.
2

Point B' is Foreign country's production point (production must

occur at the tangency between the price line with slope p a and
Foreign PPF, FF).
Notice that from the Rybczynski Theorem point B' must lie above
and to the left of point A: the higher capital endowment abroad
leads to more of good 2 and less of good 1.
The price line through point B' acts like a budget constraint for the
representative consumer in the foreign country, so that the
consumer chooses the highest indifference curve on the price
line.
Since tastes are homothetic, the foreign representative consumer
will demand the two goods in exactly the same proportion as the
home representative consumer.
In other words, the foreign consumption point must lie on the
budget constraint through point B', and also on a ray from origin
through point A.
So the foreign consumption point is at point C', which is above
and to the right of point A.
Points B' and C' do not coincide.
This means that the relative price p a at home cannot equal the
autarky price abroad. At this price there is an excess demand for
good 1 in the foreign country.
This excess demand will bid up the relative price of good 1, so
that the foreign autarky price must be higher than at home, p a*>
pa .

Situation under Free Trade:

Let:
z(p)= excess demand for good 1 at prevailing price p at Home,
z*(p)= excess demand for good 1 at prevailing price p at Foreign.
Therefore,
z(p)+ z*(p)= World excess demand at a common price p.

A free trade equilibrium occurs when world excess demand is

equal to zero.

The Home autarky equilibrium satisfies z(pa)=0.

But we know that z*(pa)>0.
Therefore z(pa)+ z*(pa)> 0. This means that at home autarky
relative price, there is an excess demand for good 1 in the
world.
If instead we reversed the argument in our figure and started with
foreign autarky price satisfying z*( p a*)=0, then we could readily
prove that z( pa*)<0 (i.e. at Foreign autarky price, there is excess
supply of good 1 at Home). It follows that the world excess
demand would satisfy z( pa*)+ z*( pa*)<0.
4

Then by continuity of excess demand functions, there must be a

price, p with
pa*> p> pa
such that, z(p) + z*(p)= 0.
This is the equilibrium price with free trade.

Illustration of Free Trade equilibrium:

y2

y2
F
slope=p

B*

A*
H

C
B

C*

slope=p
H
y1

y1
(a)

Home

Country

(b) Foreign Country

In panel (a), we show the equilibrium at Home. Beginning at the

Home autarky point A, the relative price of good 1 rises at Home,
p> pa. Now production occurs at B (where the price line through
point B has a slope of p) and consumption occurs at C (where
price line acts as a budget line and utility is maximized).
5

The difference between production point B and consumption point

C is made up through exporting good 1 and importing good 2
(illustrated by the dotted 'trade triangle').
The trade pattern at Home establishes the HO theorem.
In panel (b), the reverse pattern of trade occurs in Foreign: the
relative price of good 1 falls, pa*> p. Production moves from the
autarky equilibrium at point A* to B* and consumption occurs at
C*. Due to this difference in production and consumption point,
good 1 is imported and good 2 is exported.

Notice that the 'Trade Triangles' drawn at Home and Foreign are
identical in size. This means that the exports of one country must
be imports of the other.
HO Model:
establishes the trade pattern and
has precise implications for who gains and who loses from
trade.

Implications for who gains and who loses from trade:

The abundant factor in each country gains from trade and the
scarce factor loses.
This result follows from the pattern of price change (pa*> p> pa)
and the Stolper-Samuelson Theorem.
With the relative price of good 1 rising at Home, the factors used
intensively in that good (labor) will gain in real terms and the
other factor (capital) will lose.

Notice that labor is the abundant factor at home. Labor would have been earning less in
Home autarky equilibrium than in the Foreign autarky equilibrium. However, with free trade,
the Home country can shift production towards the labor-intensive good and export it,
thereby absorbing the abundant factor, without lowering wage.
Factor prices are equalized after trade.
Thus, the abundant factor, whose factor price was bid down in autarky, will gain from the
opening of trade, while the scarce factor in each country loses.