The Model by MikeJenny

VIEWS: 8 PAGES: 28

									Chapter 3- The H-O Model of International Trade

The list of topics discussed in this chapter:

1. Introduction: How the set up and the
assumptions of the Heckscher-Ohlin model of
international trade are different from the model
we learned before (The Ricardian Principle of
Comparative Advantage).
2. How to derive the Production Possibility
Frontier for the H-O model (used in the welfare
analysis of free trade versus self-sufficiency)
3. Two important analytical "comparative static"
results of the H-O model- the Stopler Samuelson
Effect and the Rybczynski Effect- that help us set
up the model of trade between two countries and
derive important income distribution and welfare
effects of free trade between those countries
4. The income distribution effects of free trade
5. The welfare effects of free trade
6. Reconciling an apparent paradox- the overall
welfare benefits of free trade with losses of income
to certain factors of production in an economy
7. Statement and summary implications of the H-O
model- Basis for beneficial free trade and the

                                                   1
political economy of free trade (understanding the
opposition to free trade)

8. The effects of free trade on wages (and rents) in
the two countries--the Factor Price Equalization
Theorem-- and its implication for the incentive of
factors of production to migrate from one country
to another


1. Introduction: How the set up and the
assumptions of the Heckscher-Ohlin model of
international trade differ from the model we
learned before (The Ricardian Principle of
Comparative Advantage).
This model has one important insight not offered by the Ricardo's principle of
comparative advantage: that of explaining the income distribution effects of free
trade and the political economy of opposition to free trade by certain groups in the
economy. The Ricardian model by increasing the real income of the one type of labor
due to free trade--who is also a consumer in the model--does not generate any
explanation for why some groups oppose free trade pacts.

The H-O model also provides other important insights regarding a second source of
beneficial trade--in addition to the Ricardian model-- and the effect of free trade on
the migration of labor and capital between countries.

The basis for mutually beneficial trade between the two countries is rooted in
differences in the relative endowment of factors of production, not in the differences
in the know-how (of labor) as in the Ricardian model. Clearly, in this world,
countries will produce their goods with two or more factors of production. Here we
present the essential two countries, two goods, and two factors model, called also the
Factor Proportions Theory of trade or the Heckscher-Ohlin model of trade (after the
                                                                                     2
two Swedish economists, Eli Heckscher and Bertil Ohlin who originally introduced
the model in 1920s). To appreciate the new insights we are going to learn from the H-
O model, let's first write down the full assumptions for this theory and contrast it with
those of the Ricardo's principle of comparative advantage:

The full assumptions of the H-O model (illustrated by a specific example):
- Two countries: Mexico and U.S.
- Each country produces two goods: Software (S) and clothing (C).
- Each good uses two factors of production: labor and capital (in a CRS production
function). Factors of production can not migrate between countries.
- Good S is relatively capital intensive:
(K/L)S > (K/L)C
- The technology of production (labor cost) for each good in each country is the
same, that is, there are no Ricardian type differences in labor/capital costs of
production of a unit of a good between the two countries! As a way of contrasting
this model with that of Ricardo's principle, the table of labor and capital requirements
per unit of output of each good in U.S. and Mexico in the H-O model could look like:

                                  Table 1

         Labor requirement                       Capital requirement
      Clothing          Software               Clothing          Software

U.S.         3               1                        2                   5
Mexico       3               1                        2                   5

As the fixed coefficient production example above shows, there are no differences in
the relative costs of labor or capital in the two countries. [As we will see, the H-O
model assumes a variable coefficient production function with a downward sloping
MPL, but in the example above, to produce a simple contrast with the Ricardo's
principle, we use tables of fixed coefficients for labor and capital].
- U.S. is the relatively capital abundant country, while Mexico is the relatively labor
abundant country. That is, the ratio of the stock of capital to labor in the U.S. is larger
than a similar ratio for Mexico:
(K/L)U.S. > (K/L)Mex

To compare the assumptions of the Ricardian principle of comparative
advantage and the present H-O model we'll be learning, let's look at the
following table:



                                                                                          3
 Ricardo's Principle:                     Heckscher-Ohlin Model:

 - Two countries                          - Two countries
 - Two goods                              - Two goods
 - One factor of production               - Two factors of production
 - Constant Returns to Scale              - Constant Returns to Scale technology
 technology                               - Basis of trade based on differences in
 - Basis of trade based on                the "relative endowment" of factors of
 differences in labor "know-how"          prod. No productivity differences here!
 or differences in the relative           - Though everyone benefits as
 productivity of labor.                   consumers, there are losses in real
                                          income (wage) of one type of factor of
 - Everyone benefits from free            production (the relatively scarce
 trade here!                              factor).
                                          - Explains trade between developing
                                          and developed countries based on
                                          relative resource differences.



2. How to derive the Production Possibility
Frontier for an economy in the H-O model (used in
the welfare analysis in free trade versus self-
sufficiency)
Since we'll make use of the graphical analysis of welfare effects of free trade using
the production possibility frontier (PPF), we first need to derive it. In order to
accomplish this task, we first introduce the concept of production isoquants for
clothing and software and then make use of a box diagram--the coordinates of which
are the total amounts of labor and capital in the economy-- to derive the PPF. The
smooth convex production isoquants-- for the relatively labor intensive clothing and
the relatively capital intensive software are drawn below.


                                                                                     4
                                 Graph 3-1



                     Clothing                                     Software
    K                                       K




                                                                    Qs = 1
                                   Qc = 1




                                      L                                      L




As clothing is relatively labor intensive, production of one unit of clothing--
represented by the isoquant marked by QC = 1--requires more labor relative to capital
for some “wage-rental” ratio (the relative price, or, rate of exchange between labor
and capital—the slope depicting the relative wage for labor to rent on capital is
shown in blue) than that of software. In contrast, to produce one unit of software, as
shown in the graph, requires a smaller labor to capital ratio. As the production
function is constant returns to scale, at a given wage-rental ratio (the relative price of
the factors of production used by the producers of clothing and software), doubling
the output of any of these goods requires doubling of all inputs used in the production
of that good.

Now let's use the concept of production isoquant together with the assumption that
clothing production is relatively labor intensive while software production is capital
intensive and put them together to derive the PPF in the H-O model for a given total
stock of capital and labor in an economy.


                                                                                         5
In the box diagram below, the lower left hand corner marks the origin for the clothing
production isoquants. The upper right hand corner marks the origin for software
production isoquants (turned upside down!). The horizontal axis as shown in the box
diagram spans the total stock of labor in this economy. The vertical block depicts the
total amount of stock of capital.




                             Graph 3-2



                                                            Ma x C lo thing = 8




                                                             K stoc k
                          Qs = 6



                                                   Qc = 4

                                               Qs = 5

Origin for                         Mid point
Clothing
                                   L stoc k

      Max software = 10




                                                                                     6
                                Graph 3-3
           oftware
                Max = 10
     Q of S




              6

             5




                            4         Q of Clothing
                                             Max = 8


As the box graph shows, the maximum amount of clothing produced in this
economy-shown by the highest clothing isoquant going through the origin of
software at QC = 8 - is 8 units. Likewise, the maximum amount of software
                                                                             7
produced, where all K and L are devoted to the production of software, would be
illustrated by the software isoquant going through the origin of clothing. That amount
in the graph is depicted as 10 units.

To draw the PPF, we go to the second graph drawn below the box diagram, where the
axes appropriately signify the units of clothing and software. On this graph, we note
that the maximum amounts of clothing and software, in our example, are 8 and 10
respectively. These amounts are shown on the corresponding axes of the PPF graph.
To find the shape and curvature of the PPF, note that if half of labor and capital is
given to each sector, due to CRS, simple half of 8 and 10 units of clothing and
software will be produced. That is, the middle of the box diagram, where the
isoquants QC = 4 and QS = 5 intersect, can be depicted in the PPF graph as the mid-
point in the straight line that connects the two maximum production points.

But is the straight line between the maximum amounts of clothing and software the
PPF for the H-O model? Certainly not! Note that in the box diagram, by reallocating
our labor and capital resources, we are able to increase the production of one good--
that of software--without reducing the production of clothing. Therefore, the straight
line in the Graph 3-3 can not be the frontier for efficient production! The (Pareto)
efficient allocation of L and K is at the point of tangency between the isoquant for
clothing (QC = 4) and the new, higher isoquant for software (QS = 6). That is, point
QC = 4 and QS = 6 for clothing and software lie on the PPF in graph 3, not point QC =
4 and QS = 5. It can be deduced that the PPF for H-O model is a "bowed-out" curve,
not a straight line! This curve is drawn in Graph 3-3.


3. Two important analytical "comparative static"
results of the H-O model

a. The Stopler-Samuelson effect, or, the income
distribution effects of a change in the relative price
of a good in an economy
Consider an economy in the H-O world. It produces clothing (C), and software (S).
Each good uses labor and capital in a smooth, constant returns to scale production
function. Good C uses labor relatively intensively while good S uses capital relatively
intensively. That is for a given wage-rental ratio, and to produce, say, one unit of
either good, (K/L)S > (K/L)C.
                                                                                      8
The Stolper-Samueslon effect (after the names of two economists who
formalized the idea) can be written and explained as follows:

For an economy in the H-O world, the rise in the relative price of one good will
increase the real returns to (income of) the factor intensively used in the
production of that good and lowers the real returns to the other factor.

The analytical, yet intuitive explanation (without the use of calculus for proof) for the
Stolper-Samueslon effect goes like: suppose the price of clothing (good C) goes up in
this economy. For simplicity, suppose the price of good S does not change. Thus the
relative price of C has risen. What happens to the relative production of the two
goods? As the relative price of C has risen, you would expect production to good C to
increase as well? The answer is, yes! On the bowed-out PPF for this economy, as the
relative price of C rises, the efficient production level for the two goods changes as
well; production of good C rises while that of good S falls (see graph 4 below).

                                       Graph 3.4
                   Units of Software




                                                       New, higher
                                                       relative price
                                                       Of C

                                            Units of Clothing




How does this change in relative quantities produced--resulting from the change in
relative price-- affect incomes of labor and capital? As sector C expands, it demands
resources to be released from sector S. Since clothing is a relatively labor intensive
activity, it demands a lot of labor and a little capital to increase output. However,
these resources are released in a different intensity from software! The software
sector releases a lot of K and only a little L (it is a relatively capital intensive
                                                                                         9
activity). Thus, at the existing wage (returns to labor per hour of labor hired) and rent
(returns to capital per hour), an excess demand for labor, and an excess supply for
capital develops. Therefore, real wage will rise (both in terms of clothing whose price
has risen and in terms of software whose price has not changed) and the real rent will
fall. Therefore, a rise in the relative price of the labor intensive good--good C-- has
raised wage by a greater proportion than the rise in the price (hence the rise in the
real wage, W/P) and lowered rents.

This analysis implies that there are income distribution effects of a change in the
relative price of a good. That is, there are losers (here, owners of capital) and winners
(here, workers) as the relative price changes in favor of a good. This result will be
used in analyzing the income distribution effects free trade and the political economy
of opposition to free trade pacts.

b. The Rybczynski Effect: The effects of an
increase in the relative quantity of a factor of
production on the relative level of output.
Here, we analytically illustrate how, in a H-O setting, a change in the relative
quantity of a factor of production will lead to a greater than proportionate
change in the quantity of the good which uses that factor intensively and reduces
the amount of the other good produced. We explain this result while keeping
goods prices, wage and rent constant.

To illustrate this effect which helps derive our welfare and income distribution
results, we can use the same box diagram as in Graph 3-2 (keep the allocation point
A, but drop the graphs of production isoquants) and analyze the effects of increasing,
say, the supply of labor.




                                                                                       10
                           Graph 3.5




                                   Origin for Software




                                                                  K stoc k
For Clothing
Origin




                         L stock                     L




Point A in Graph shows the allocation of the total amounts of labor and capital
towards production of clothing and software. As the ratios of capital to labor show,
the K/L for clothing is smaller than that of software (the origin of which is the upper
right hand side corner of the graph). Point A corresponds with a point on the PPF --
designating the amounts of production of each good--for this economy.

Now suppose the amount of labor in this economy increases, shown by L in the
graph. This change is illustrated by the shift of the origin and the parallel shift of the
angle depicting K/L for software. As the graph shows, the resulting change in the
allocation of resources is a more than proportionate increase in the amount of labor
allocated to clothing, and also an increase in the amount of capital allocated to this
sector. As for the software sector, the amount of K and L allocated to that sector
declines. Here, the comparative static analysis of a change in the amount of a factor
of production, keeping all else constant, produces changes in the relative amounts of
goods produced. The intuitive analysis/explanation goes like this:
Since C is the labor intensive activity, it will absorb the increase in labor. This
increase can not be absorbed by the other sector since software needs a lot of extra
                                                                                         11
capital to employ a little more labor in producing software. As we know the amount
of capital has not changed, so absorption into software is not possible! As the extra
labor is employed in C, it requires a little extra capital which will also be released
from S (together with a smaller amount of labor). Therefore, the clothing sector tends
to absorb the increase in labor and some more, hence the more than proportionate
increase in volume of good C produced and the reduction in the volume of good S.
This result can be shown in the graph 3-6 below:




                             Graph 3-6
Units of S




                                                             Units of C




                                                                                    12
As the graph shows, keeping the relative price of the two goods constant, and
increase in labor supply shifts the PPF out disproportionately on the clothing axis. At
the given relative price of clothing, the amount of good C rises more than
proportionately while the amount of good S declines.

Therefore, the increase in the amount of labor --all other variables held
constant--has resulted in a greater than proportionate increase in the amount of
the labor intensive good produced while the production of the other good has
fallen.

A useful extension to this idea is that given a set of relative prices, an economy that is
relatively abundant in labor produces a disproportionately large volume of the labor
intensive good. Similarly, an economy that is relatively abundant in capital, tends to
produce a disproportionately large volume of the capital intensive good.


4. The income distribution effects of free trade
We can now use the two comparative static results we established--the Stopler-
Samuelson and the Rybczynski effects--in order to analyze the income distribution
effects of free trade between the two countries in the H-O world.

Our two countries are U.S. and Mexico. Each country produces two goods, clothing
and software. Each good uses labor and capital in its production process. Clothing is
the relatively labor abundant good, while software uses capital relatively intensively.
In addition, U.S. is the relatively capital abundant country while Mexico has a higher
relative supply of labor.

We shall use a relative supply-relative demand graph to analyze the relative price of
clothing in self-sufficiency and in free trade for the two countries. We therefore need
to develop the concept of relative supply (RS) and relative demand (RD).

In the H-O world, the RS curve can be derived by considering the changes in the
relative price of C and deriving the changes in the relative quantity of C to S. We can
use Graph 3-4 above to simply derive the RS curve. Note that as the relative price of
C increases in Graph 3-4, the ratio of QC/QS will also rise. Essentially, the supply or
the relative supply curve for C shows the marginal cost of production of good C. This
marginal cost is an upward sloping curve, as below (Graph 3-7):



                                                                                        13
                                 Graph 3.7
                                                      RS
          PC/PS




                                                      RD



                                                     QC/QS

The relative demand is simply a regular demand curve, indicating that as the relative
price of clothing increases, the ratio of C to S purchased would fall. Hence, it can be
drawn in Graph 3-7 as a downward sloping curve.

Now, in order to compare autarky with free trade, we can draw the RS and RD for
each country, derive the relative price in autarky for each country and then compare it
to the free trade relative price of clothing.

In order to simplify our analysis, we consider the U.S. and Mexican consumers to be
identical and at each relative price, consume the same relative amounts of clothing to
software. This implies that on a graph, the RD for Mexico and the RD for U.S. would
be the same curves!

To draw the RS for each country on the same graph, note that as Mexico is relatively
labor abundant, according to the Rybczynski effect, it produces a higher relative
quantity of clothing to software at each price level. Can you tell which if the two RS
curves, A or B, belong to Mexico in the graph below (Graph 3-8)?




                                                                                      14
                                   Graph 3.8


                                                       A
                     PC/PS

                                                                   B

Autarkic rel. pric e in the U.S.




Autarkic rel. Pric e in Mexico                                         RD



                                                                   QC/QS




You guessed right! It is indeed the curve labeled as B.
The intersection of RS and RD for each country gives the relative price of C in self-
sufficiency. That is, the autarkic relative price of Clothing in Mexico is shown on the
graph to be lower than the price of Clothing in the U.S. As Mexico is relatively labor
abundant, it can produce the labor intensive good relatively cheaply. By contrast, the
autarkic relative price of good S would be cheaper in the U.S.

Let's now consider a free trade pact and construct the world relative supply and
relative demand for the two countries, U.S. and Mexico. We can use the same graph
as above (redrawn below as Graph 3.9).




                                                                                      15
                                     Graph 3.9




                                              .
                                           U.S RS
                        PC/PS
                                                 World RS pric e

                                                      Mexic o RS

Autarkic rel. pric e in the U.S.


World Relative Price

Autarkic rel. Pric e in Mexico




The world RS curve is simply the sum of production levels of U.S. and Mexico for
clothing relative to (or divided by) the sum of productions of software. As such, it
falls between the two autarkic RS curves. As for the world RD, since the two
countries have identical relative demand curves, then the same schedule would also
serve as the world RD curve.

The equilibrium world relative price of clothing is --as shown in graph 9--the vertical
height of the intersection of the world RS and RD curves. As we see, it is indeed
between the two autarkic relative prices for clothing.

How do we establish the income distribution effects of free trade between Mexico
and the U.S.? Who gains and who loses from the free trade pact like NAFTA? We


                                                                                       16
use the graph above and the Stolper-Samuelson effect explained earlier to draw our
income distribution results in the H-O model:

Let's compare the free trade relative price of C with that of autarky for Mexico. As
Mexico enters the free trade pact, the price of clothing--the labor intensive good--
goes up (inside and outside Mexico). According to the Stopler-Samuelson (S-S)
effect, this implies that a wedge is driven between income of labor and capital. That
is, the real returns to labor increases while the real returns to capital falls. Hence in
Mexico, labor would win and capital owners would lose.

In the U.S., as the free trade pact takes effect, the relative price of good C declines or,
conversely, the relative price of good S goes up. According to the S-S effect, the
returns to capital will rise and the returns to labor would fall. That is, the real wage of
labor will decline and the real returns to owners of capital will rise.

The political economy implications of this argument are clear: when trade takes place
between countries who own different proportions of various factors of production
(distinguished as developed countries which are relatively capital abundant and
developing countries which are considered relatively labor abundant), there are
winners and losers. The losers in a relatively capital abundant country are labor
(which is the relatively scarce factor). The losers in a relatively labor abundant
country are owners of capital which is the relatively scarce factor.

Therefore, for two countries in the H-O world, as free trade takes place, the relatively
abundant factor wins while the relatively scarce factor loses. As losers tend to
organize and oppose a free trade pact, in our example, labor groups would oppose
free trade in the U.S. (or another developed country) while capitalists would oppose
free trade in Mexico (or another developing country).

Empirical evidence from news, publications and the sort confirms the basic income
distribution results of the H-O model: in countries like the U.S. where labor is the
relatively scarce factor, labor groups will oppose free trade (in industries such as
textiles, apparel, agricultural products). In contrast, in countries like Iran, India, and
other developing countries, it is the capitalists (who are also close to the sources of
political power) who may oppose free trade, as much as it may help their masses of
labor.


5. The welfare effects of free trade

                                                                                             17
How do consumers in the two countries benefit from the free trade pact? How do we
analyze the net welfare effects of free trade?

In order to answer this question, let's use a graphical approach, utilizing the concept
of the production possibility frontier and comparing autarky with free trade for each
country.



                             Graph 3-10
                    .S
                   U .                                   Mexico
Units of S
              Free Trade Rela tive        Units of S
              Price for C




               b
                                                       c’

                                   c                   a’
                         a




                         Units of C




The points a and a' on the two graphs respectively show the efficient allocation of
resources in the two countries, Mexico and the U.S. to yield the highest level of
consumer welfare in autarky. Here, the community indifference curve tangent to the
                                                                                          18
PPF for each country represents the highest level of welfare reached in self
sufficiency for that country.

Now on to free trade. The world relative price of clothing--between the autarkic
relative prices-- is shown by the thick black line. The production point for U.S. is
point b and for Mexico is b'. As you can see, due to free trade, production of clothing
increases and that of software decreases in Mexico, and vice versa for the U.S. Now
that the relative price for everyone is the new world price, consumers in each country
will also make their best consumption choices which are points c and c' on the
graphs. As c and c' lie on a higher indifference curve than in autarky, consumer
welfare (indeed net welfare for the whole economy) has increased. Therefore, free
trade can potentially make everyone (as consumers) better off.

To show the net welfare change from a different angle, we can employ a simple
supply and demand graph for one market, say, clothing in the U.S. The use of supply
and demand analysis for one good helps us see the net welfare effects of free trade in
a partial equilibrium context. We consider the market for clothing in the U.S., where
clothing is an import competing good.

The market for clothing in the U.S. is shown in Graph 3-11 below. The intersection
of domestic S and D curves shows the equilibrium price and quantity in autarky. As
the price of clothing decreases due to free trade in the U.S., the level of consumer
surplus (welfare) goes up by triangles A + B + C. The loss of producer surplus
(welfare) is triangle A. So the net increase in welfare is B + C. This is equivalent of
the rise in the welfare shown on the PPF graph with the indifference curves for each
country.




                                                                                          19
                          Graph 3-11



                                                             Supply




               A                  B     C
                                                        Free trade pric e


                                                             Demand



                                            Quantity of Clothing

What is the intuitive explanation for the welfare increase due to free trade?
Each country produces more of the good that it can produce relatively cheaply (and
sells it for a relatively higher price!) and then consumers are freed from buying what
only their own economy can produce; they may choose to buy (import) more of the
cheaper good and sell (export) more of the surplus of their relatively expensive good.
Thus the real income of inhabitants in each country is enhanced, and alongside it,
their level of welfare.

6. Reconciling an apparent paradox- the overall
welfare benefits of free trade with losses of income
to certain factors of production in an economy
So far, we have established that in each country, with free trade, there are net welfare
gains and yet some group--namely the scarce factor--lose due to free trade. How do
we reconcile this apparent paradox?

                                                                                      20
Note that the stated welfare effect is that there are net welfare gains. That is, once all
the losses have been subtracted from the total benefits, there are some net gains left
over. This implies that the welfare gains are indeed larger (at times much larger) than
any income losses incurred to a particular factor of production (in the H-O model,
this would be the relatively scarce factor of production in a country). This means that
at least theoretically, losers can be compensated by the gainers and there will be some
net gains left. This analysis produces a strong argument in favor of free trade.

As an example, suppose U.S. makes a free trade pact with Mexico. The price of
clothing, the import good for the U.S. then falls by say, $5 a piece. Suppose the
population of the U.S. is about 280 million people. As all Americans buy clothes, that
adds up to savings of 280*$5 = $1400 million. That is the overall benefits to
consumers, in this simple calculation, is $1400 million or $1.4 billion a year.

Now consider the losers from free trade. These are the scarce factor, labor in the U.S.
The H-O model would predict a lower real income for labor as a result of free trade,
but consider a more sever outcome: suppose that workers (most of whom would be
employed in clothing) lose their job. Imagine 10,000 U.S. clothing workers losing
their jobs due to free trade, where each used to earn $35000 a year. The total loss of
income would then be:

10,000* $35000 = $350 million. Subtracting this loss of $350 million from the gains
of $1400 million, the net gains are $1400 - $350 = $1050 million. That is, each
consumer, in theory, could pay part of his/her gain to compensate workers who have
lost their jobs and still have some benefits of free trade left. Of course, if this system
of compensation existed, then we would not see the vocal, organized opposition to
free trade pacts by the labor unions (in textiles and apparel) in the U.S.

Why doesn’t such a system of compensation of losers exist? There is of course a
worker compensation adjustment program which has existed since NAFTA was put
into effect. This government program compensates workers who have lost their jobs
due to NAFTA. The trouble is that it is not always easy to tell whether a worker loses
his/her job due to competition from abroad, or competition from inside the country,
or due to technological changes that may make a job obsolete. There are not
necessarily any programs that would compensate a worker who loses his/her job in a
firm due to technological advancement and addition of labor saving capital
equipment in that company. We should wonder why job losses due to free trade
would be treated any differently.

Case in Point

                                                                                         21
The Wall Street Journal (Monday, June 30, 1997) reports that many laid off
workers in various U.S. industries receive NAFTA related unemployment
benefits while there is no evidence of lay offs having anything to do with
NAFTA! In one case, in closing of a sawmill in Port Gamble, WA, the reason for
the closure of the plant was cited as simply lack of availability of logs. The
culprit in this case was the spotted owl debate that closed the logging areas and
led to the closing of the sawmill, not NAFTA! However, the U.S. Department of
Labor certified all the laid off workers of the plant for NAFTA aid! In another
example, the laid off workers of Smith Corona Corporation applied and
received NAFTA aid because the company had moved its operation from
Cortland, N.Y. to Mexico. The company officials mention that the move to
Mexico took place two years before the NAFTA agreement. It had to do with-as
the company officials argue- “a flood of low priced products from Japan” and
was not related to NAFTA. 1

The important point here is that while the winners of free trade are millions of
consumers each of which may have a small gain--though the total benefits of free
trade across the economy will be very large-- the loser are concentrated and each one
stands to lose a large sum, perhaps their entire salary if they lose their job. Therefore
the losers are more concentrated, vocal, organized against free trade than the winners
(consumers) are in favor of it. The analytical framework provided by the H-O model
helps explain the uncomfortable relationship many people have with the idea of free
trade: it seems to be good since we like and advocate free exchange and free markets
in our own economy, but somehow when it comes to international trade, free
exchange of goods and services between economies does not seem such a good idea!
The H-O model with its income distribution analysis helps us understand this
phenomenon.


7. Statement and summary implications of the
Heckscher-Ohlin model: Basis for beneficial free
trade and the political economy of free trade
(understanding the opposition to free trade)
The statement of the H-O theorem: A country has comparative advantage in a good
that uses its relatively abundant factor intensively (e.g., labor). In free trade, this
economy will produce more and export some of this (e.g., labor intensive) good to
the other country and in turn import a part of its consumption of the other (e.g.,
capital intensive) good from its trading partner.
                                                                                          22
Note that in this and all other models of trade, the trade balance is zero (there is no
surplus or deficit in the trade balance as this and other trade models are essentially
micro-economic in nature. They produce "equilibrium" results).

Let's summarize what we have learned so far from the H-O model:

1. The basis of comparative advantage and beneficial free trade lies in the differences
in the relative abundance of factors of production across two countries.

2. Free trade increases the consumption possibilities (shifts the consumption
possibility set outward) by freeing the consumers from having to consume what is
produced (on the PPF). Trade frees consumers from the constraints of production
possibilities

3. Welfare increases as consumers are able to buy import goods cheaper, while the
export good is sold at a higher relative price (than the autarkic relative cost) in the
world market.

4. Free trade leads to a divergence in returns to the various factors of production in
each economy: the abundant factor receives a higher real income and the scarce
factor receives a lower real income in each economy. The losers will usually oppose
free trade.

5. In intuitive terms, trade creates a larger economic (consumption) pie for the
economy, increasing welfare. But the pie will be sliced differently, with the scarce
factor receiving a smaller slice than before!



8. The effects of free trade on wages (and rents) in
the two countries--the Factor Price Equalization
Theorem-- and its implication for the incentive for
factors of production to migrate from one country
to another

Now we look at another important implication of the H-O model of trade. This effect
is called the Factor Price Equalization Theorem (FPE theorem) and it grows out of
                                                                                          23
the analytical logic of the H-O world. This effect has important insights for us
regarding the effects of free trade in goods on the rate of migration of factors of
production (labor and capital) between countries.

It was argued that with NAFTA, migration of illegal immigrants from Mexico into
the U.S. would decline or completely dry out. We shall see how the model generates
this result: based on the differences in wages and rents, labor and capital have an
incentive to migrate where pay is higher. With the strict assumptions of the H-O
model, once free trade takes place in goods, there would be no incentive for labor or
capital to migrate. This follows from the implication of the model regarding the
differences in wages and rents between countries before and after free trade in goods.
That is, the model establishes that once free trade in goods takes place, wages across
U.S. and Mexico will be exactly the same and so would rents in the two countries. In
this case, once free trade takes place, there will be no incentive for labor or capital to
take place, even if the borders were to open and allow free movement of labor and
capital!

To establish or illustrate this result, let's take a simple example of determination of
wages and rents in each country before and after free trade. For simplicity, we use the
data from Table 1 in the beginning of the chapter:

Every unit of clothing produced in either country uses 3 hours of labor and 2 hours of
capital services.
Every unit of software produced in either country uses 1 hour of labor and 5 hours of
capital services.

Since we have perfect competition and hence zero economic profits in each industry
of each country, then the value of output of each good is equal to the cost of
production of that good, i.e., in autarky:

For Mexico:

PCMex QCMex = wMex LC + rMex KC
PSMex QSMex = wMex LS + rMex KS

Where w and r are the wage and rent for the two factors of production, labor and
capital. QC and QS refer to the volume of C and S produced in Mexico in autarky,
using L and K.

We can write the same relationship for the U.S. in autarky:
PCUS QCUS = wUS LC + rUS KC
                                                                                        24
PSUS QSUS = wUS LS + rUS KS

Now, let's do a simple numerical example to establish w and r in each country in
autarky and then in free trade. In order to use the information in Table 1, we can
divide each equation by the corresponding Q, quantity of production:

For Mexico:

(PCMex QCMex)/ QCMex = wMex (LC/ QCMex) + rMex (KC/ QCMex)

(PSMex QSMex)/ QSMex = wMex (LS/ QSMex) + rMex (KS/ QSMex)

This would be simplified into:
PCMex = wMex aLCMex + rMex aKCMex

PSMex = wMex aLSMex + rMex aKSMex

A similar form would be derived for the U.S.:

PCUS = wUS aLCUS + rUS aKCUS

PSUS = wUS aLSUS + rUS aKSUS

The per unit labor and capital requirements, aLC , aKC, etc…can be replaced by their
numerical values from Table 1. That is, aLC = 3 for both countries, aKC = 2 for both
countries, etc.

Therefore, for Mexico:
PCMex = wMex 3 + rMex 2
PSMex = wMex 1 + rMex 5

Also for the U.S.:
PCUS = wUS 3 + rUS 2
PSUS = wUS 1 + rUS 5

Note above that the only factor that would make wage (and rent) in Mexico to be
different from wage (and rent) in the U.S. is the fact that the prices of the two goods
would be different in the two countries! (In fact, the autarkic price of clothing in U.S.
would be higher than that of Mexico as U.S. is relatively scarce in labor and vice
versa, and this difference would create higher wage in the U.S. than in Mexico in
autarky. The same analysis applies to differences in rents).
                                                                                       25
Now, consider free trade. In free trade, prices of the two goods would be exactly
equal in the two countries, wouldn't they? Therefore the two sets of equations for
U.S. and Mexico would look exactly the same! This means that they would render
exactly the same outcome for determination of wage across the two countries. The
same goes for rents. In short, once free trade in goods takes place, as the goods prices
would equalize, with the same production functions, Mexico and U.S. would pay
exactly the same wages to their workers, and exactly the same rents to their
capitalists!
The above analysis is called the Factor Price Equalization Theorem. It has a powerful
implication for labor and capital migration in free trade: it halts the incentive for all
migration! Since wages in the two countries would be the same, there would be no
incentive for labor to migrate from Mexico to the U.S. (if indeed the differences in
wages are the main reason for migration). In this manner, if the world conformed to
the H-O model, the U.S. borders would be left open after NAFTA and no one would
cross the border!2
What is taking place is a useful insight: in fact while labor had been prevented to
migrate before, with the advent of free trade, the services of that labor, embodied in
the labor intensive good (clothing) will flow to the U.S. and its effect on wages is the
same as if labor itself migrated to the U.S. Indeed, trade in goods is implicitly, trade
in services of factors of production across countries. So while labor from Mexico
could not migrate before, its services embodied in clothing are going to the U.S. and
in this model, its effect on wages of labor in Mexico is the same as if workers moved
to the U.S. (which would equalize wages across countries). This implies that, in the
H-O model, trade in goods and movements of factors of production are perfect
substitutes: If goods are free to move, there will be no migration of factors of
production and vice versa!

Of course this prediction has not happened and for a good reason: the world does not
comply with the H-O model, indeed the job of a good model is not to comply too
closely with the real world, but to be able to take some main, simplified features and
provide a basis for understanding the various aspects of reality we see. In this case,
the H-O model creates a great standard of comparison with reality as it allows us to
understand why, in the face of NAFTA, immigration (in its illegal form) from
Mexico into the U.S. indeed continues.

We have to find the answer in the simplifying assumption of the model! There are a
few assumptions in the H-O model which when relaxed, will help explain why in the
face of NAFTA which was supposed to reduce or eliminate the flow of migration, we
still have many people trying to cross the border and work in the U.S.

Let's list the assumptions and how they differ from reality:
                                                                                       26
1. The model assumes that the technology of production of clothing and software is
the same for U.S. and Mexico. That is, the factories that produce clothing have
exactly the same technological features whether they are located in the U.S. or in
Mexico. This, of course does not hold in reality. If workers in the U.S. work with
fancier machines and are as a result more productive than their counter parts in
Mexico, then the wages would not equalize in free trade. As we saw, wages are
determined from productivity of labor in different sectors and the differences in
technical ability of workers would keep wages different across countries.

2. The model assumes that both countries produce both goods. Indeed the H-O
model requires that all countries produce the same bundle of goods in free trade. Of
course, in reality, some countries do not produce some goods (e.g., the U.S does not
produce coffee). Since wages will be determined from labor productivities from
across various sectors, if those sectors do not coincide between countries, then there
is no reason to expect the wages to be the same after free trade in goods. Certainly
where some countries specialize in production of some goods and not others, the
wages in these countries and their trading partners may not be comparable. This may
be quite true of U.S. -Mexico trade where some products are produced only in
Mexico and not the U.S.

3. The model also assumes that price of a good in free trade should be identical in the
two countries. This is again useful for deriving our clear results, but not true in
reality. There are transportation costs, tariffs, and other fixed price policies by the
government that would render prices to be different in the two countries for the same
good. As we will analyze in Ch. 8, imposition of an import tariffs would imply that
the prices of goods inside and outside of a country are not the same. From our
equations above, we realize that if prices are different, so will wages in the two
countries (also rents will be different).

These simple comparisons between the model and reality provide a great insight as to
why labor continues to migrate to the U.S. in spite of the fact that they are now
needed to produce (labor intensive) export goods for the U.S. market right from
Mexico.

Endnotes

1. The Wall Street Journal, “Shaky Numbers: Layoffs Not Related to Nafta Can
Trigger Special Help Anyway”, Monday, June 30, 1997



                                                                                     27
2. Researchers and policy analysts have argued that free trade pact between U.S. and
Mexico will reduce the flow of (illegal) immigration from Mexico into the U.S. For
example Philip Martin of UC-Davis argues, “Free trade and investment are the only
instruments guaranteed to eventually reduce migration pressures.” And in the same
piece, “Europeans tend to favor aid rather than trade to reduce migration pressures, in
part because many of the emigration countries would, with freer trade, export
agricultural products to Europe. In other words, agricultural protections are in part
responsible for urbanization and migration pressures from Morocco to Turkey.” From
the Abstract: Labor Market Aspects of Immigration
by Philip Martin, Dept of Agricultural Economics, UC-Davis.




                                                                                     28

								
To top