Lecture 3: Two-factor

economy: The Heckscher-

Ohlin model
nttuyen@hcmiu.edu.vn

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 Content
1. Model of a Two-factor Economy
 Prices & production
 Choosing mix of inputs
 Factor prices & Good prices
 Resources & Output
2. Effects of International trade between Two-factor Economies
 Relative prices & the pattern of trade
 Trade and the distribution of income
 Factor-price equalization

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 1. Two-factor Economy
 In the real world, while trade is partly explained by differences in
labor productivity, it also reflects differences in countries’
resources.
 The Heckscher-Ohlin theory:
Emphasizes resource differences as the only source of trade
Shows that comparative advantage is influenced by:
Relative factor abundance (refers to countries)
Relative factor intensity (refers to goods)
Is also referred to as the factor-proportions theory (2 by 2 by 2)

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 1. Two-factor Economy
▪ Assumptions of the Model
•An economy can produce two goods, cloth (C) and food (F)
•The production of these goods requires two inputs that are in
limited supply; labor (L) and land or capital (K).
•Production of food is land-intensive and production of cloth is
labor-intensive in both countries.
•Perfect competition prevails in all markets.
Amount produced 𝑄𝐶 = 𝑄𝐶 (𝐾𝐶 , 𝐿𝐶 )
𝑄𝐹 = 𝑄𝐹 (𝐾𝐹 , 𝐿𝐹 )
K & L are fixed supply of capital & labor in the economy

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 1.1 Prices & production

- Assume that the immobile factors that were specific to each sector
(capital in cloth, land in food) are now mobile in the long run. In the long
run, both capital and labor can move across sectors, thus equalizing their
returns (rental rate and wage) in both sectors.

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 Production possibility frontier
No possibility of substituting labor for capital or vice versa

To produce 𝑸𝑪 :
𝑎𝐾𝐶 = 2
𝑎𝐾𝐶 ∗ 𝑄𝐶 + 𝑎𝐿𝐶 ∗ 𝑄𝐶 Constraints:
= 2𝑄𝐶 (𝑤𝑟𝑘 ℎ𝑟𝑠) 𝑎𝐾𝐶 ∗ 𝑄𝐶 + 𝑎𝐾𝐹 ∗ 𝑄𝐹 ≤ 𝐾
𝑎𝐿𝐶 = 2
+ 2𝑄𝐶 (𝑚𝑐ℎ ℎ𝑟𝑠) 𝑎𝐿𝐶 ∗ 𝑄𝐶 + 𝑎𝐿𝐹 ∗ 𝑄𝐹 ≤ 𝐿

2 ∗ 𝑄𝐶 + 3 ∗ 𝑄𝐹 ≤ 3,000
𝑎𝐾𝐹 = 3 To produce 𝑸𝑭 : 2 ∗ 𝑄𝐶 + 𝑄𝐹 ≤ 2,000
𝑎𝐾𝐹 ∗ 𝑄𝐹 + 𝑎𝐿𝐹 ∗ 𝑄𝐹
𝑎𝐿𝐹 = 1
= 3𝑄𝐹 𝑤𝑟𝑘 ℎ𝑟𝑠
+ 𝑄𝐹 (𝑚𝑐ℎ ℎ𝑟𝑠)

Assume K= 3,000 units of machine – hours, L= 2,000 units of work – hours.

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 Production possibility frontier
2 ∗ 𝑄𝐶 + 3 ∗ 𝑄𝐹 ≤ 3,000 (capital)
2 ∗ 𝑄𝐶 + 𝑄𝐹 ≤ 2,000 (labor)

• Production possibility frontier is

the kinked red line
• The opportunity cost of cloth is
is higher when more units of
cloth are being produced
(from 2/3 to 2 when moving
from left to right).

No possibility of substituting labor for capital or vice

versa
***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU
 Production possibility frontier
Allow the possibility of substituting
labor for capital or vice versa
Kink is removed. Opportunity cost of cloth
increases when more cloth is produced.

➢ Where to produce? Depend on prices

➔maximize value of production
𝑉 = 𝑝𝐶 ∗ 𝑄𝐶 + 𝑝𝐹 ∗ 𝑄𝐹
𝑝𝐶 : Price of Cloth
𝑝𝐹 : Price of Food

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 Production possibility frontier
 Insovalue lines have
constant output value, slope
= −𝑝𝐶 /𝑝𝐹
 Produce at point Q, the
slope of the PPF = −𝑝𝐶 /𝑝𝐹
➔ The opportunity cost of cloth
is equal to the relative price of
cloth 𝑝𝐶 /𝑝𝐹 .

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 1.2 Choosing mix of inputs
 Producer faces trade-offs of input
mix
 The input choice will depend on the
𝑤
ratio (factor prices)
𝑟
𝑤: wage rate
𝑟: rental cost

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

1.2 Choosing mix of inputs

 Factor Intensity:
At any given factor prices, production of
cloth will always use more labor relative to
capital (L/K) than will production of food.
𝐿𝐶 𝐿𝐹
>
𝐾𝐶 𝐾𝐹
 Example: If food production uses 80
workers and 200 land acres, while cloth
production uses 20 workers and 20 acres,
then food production is land-intensive
and cloth production is labor-intensive.

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 1.2 Choosing mix of inputs
 Substitution effect in producer’s factor
demand:
 As wage rises relative to rental, producer
substitutes capital for labor in their
production decisions.

𝑤 𝐿
𝑟 𝐾

CC and FF are relative factor demand curves

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 1.3 Factor Prices and Goods Prices
Stolper-Samuelson Theorem
(effect):
If the relative price of a good
increases, holding factor supplies
constant, then the nominal and
real return (in terms of both goods)
to the factor used intensively in
the production of that good
increases, while the nominal and
real return (in terms of both goods)
to the other factor decreases.
The reverse is also true.
Cloth is labor-intensive
***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU
1.3 Factor Prices and Goods Prices
An increase in the price of cloth
relative to that of food, PC/PF ,will:

• Raise the income of workers

relative to that of landowners, w/r.
• Raise the ratio of land to labor, K/L
(or reduces L/K), in both cloth and
food production and thus raise the
marginal product of labor in terms
of both goods.
• Raise the purchasing power of
workers and lower the purchasing
power of landowners, by raising
real wages and lowering real rents
in terms of both goods.

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 1.4 Resources and Output
 Given relative price of cloth unchanged
(slope –Pc/PF), increase in labor force (L/K
increases)
➔ The production possibility frontier shifts
outward much more toward cloth production
direction than food (disproportionally) 
biased expansion of production possibilities
➔ the economy produces more cloth and
less food.
 Rybczynski Theorem (effect): If a factor of
production (T or L) increases, then the supply
of the good that uses this factor intensively
increases and the supply of the other good
decreases for any given commodity prices.

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 2. Effects of International Trade Between Two-
Factor Economies
 Assumptions of the Heckscher-Ohlin model:
• There are two countries (Home and Foreign) that have:
• Same tastes
• Same technology
• Different resources
• Home has a higher ratio of labor to land than Foreign does
(Home is labor-abundant, Foreign is capital-abundant)
Each country has the same production structure of a two-factor
economy.

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 2.1 Relative Prices and the Pattern of Trade
Factor Abundance
Home country is labor-abundant compared to Foreign country (and
Foreign is land-abundant compared to Home) if and only if the ratio
of the total amount of labor to the total amount of land available in
Home is greater than that in Foreign:

L/K > L*/ K*

Example: if America has 80 million workers and 200 million acres, while
Britain has 20 million workers and 20 million acres, then Britain is labor-
abundant and America is land-abundant.
In this case, the scarce factor in Home is land and in Foreign is labor.

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

2.1 Relative Prices and the Pattern of Trade
 Home has larger relative supply of cloth
(higher 𝑄𝐶 /𝑄𝐹 ), thus Home supply curve
(RS) lies further to the right than
Foreign’s (RS*)
 RD: relative demand curve
 No international trade: Home
equilibrium is point 1, Foreign’s is point 3
𝑃𝐶 𝑃𝐶∗
➔ < ∗
𝑃𝐹 𝑃𝐹
 With trade, relative prices converge to
point 2.

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 2.1 Relative Prices and the Pattern of Trade
When Home and Foreign trade with each other, their relative prices
converge. The relative price of cloth rises in Home and declines in
Foreign.
In Home, the rise in the relative price of cloth leads to a rise in the production of
cloth and a decline in relative consumption, so Home becomes an exporter of
cloth and an importer of food.
Conversely, the decline in the relative price of cloth in Foreign leads it to become
an importer of cloth and an exporter of food.

Heckscher-Ohlin Theorem:
A country will export that commodity which uses intensively its
abundant factor and import that commodity which uses intensively its
scarce factor.

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 2.2 Trade and the Distribution of Income
Changes in relative prices have strong effects on the relative
earnings of labor and land in both countries:
• In Home, where the relative price of cloth rises:
Laborers are made better off and landowners (capital owners) are
made worse off.
• In Foreign, where the relative price of cloth falls, the opposite
happens:
Laborers are made worse off and landowners are made better off.
Owners of a country’s abundant factors gain from trade, but
owners of a country’s scarce factors lose.

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 2.3 Factor Price Equalization
In the absence of trade: labor would earn
less in Home than in Foreign, and land
would earn more.
Factor-Price Equalization Theorem:
International trade leads to complete
equalization in factor prices of
homogeneous factors across countries.
It implies that international trade is a
substitute for the international mobility of
factors. Home exports its labor (by
exporting cloths), Foreign exports its
capital.

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 2.3 Factor Price Equalization
Has international trade equalized the returns to
homogeneous factors in different countries in the real world?
Even casual observation clearly indicates that it has not.
Example: Wages are much higher for doctors, engineers, technicians,
mechanics and laborers in the United States and Germany than in Korea and
Mexico.
Under these circumstances, it is more realistic to say that
international trade has reduced, rather than completely eliminated,
the international difference in the returns to homogeneous factors.

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

Comparative International Wage Rates (United States =
100)

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU

 2.3 Factor Price Equalization

Three assumptions crucial to the prediction of factor price

equalization are in reality untrue:
Both countries produce both goods
Both countries have the same technologies in production
Both countries have the same prices of goods due to trade

***Import – Export Management*** Ms. Uyen Ngo – IEM HCMIU