Application of the Heckscher-Ohlin Theory
Lecture 5

Predict Winners and Losers of Free Trade

1. Predict winners and losers of free trade
   • Use Heckscher-Ohlin Theory
   • Short run effects
     • U.S. exports wheat while China exports cars
     • U.S. is abundant in land
     • China is abundant in machines and equipment
     • Both engage in free trade
2. U.S. Wheat industry expands
   • Derived demand – farmers use more land and labor
   • Derived demand – consumers' demand links a businesses' demand for resources
   • Rental price of land increases, because farmers increase demand for land
   • The wage rate increases for workers in the wheat industry, because farmers hire more workers

U.S. Land Market Used in Wheat Industry	U.S. Labor Market Used in Wheat Industry

3. U.S. car industry contracts
   • Derived demand – firms use less machines and equipment, and less labor
   • Price of capital decreases, because lower demand for capital
   • Wage rates for auto workers decreases, because car factory reduce their workforce

U.S. Machines Market Used in Car Industry	U.S. Labor Market Used in Car Industry

4. Chinese car industry expands
   • Derived demand – firms use more machines and equipment
   • Price of capital increases, because higher demand for capital
5. Chinese wheat industry contracts
   • Derived demand – farmers use less land
   • Rental price of land falls
6. Long run effects
   1. Firms can enter or exit an industry
   2. Resources can move between industries
   3. Engage in trade
      • U.S. Wheat industry expands
        • Labor migrates from car manufacturing to wheat industry
        • Derived demand – labor is represented by supply function
        • Labor supply shifts left in car industry
          • Thus, wage rates increase
        • Labor supply shifts right in wheat industry
          • Thus, wage rates fall

U.S. Labor Market Used in Wheat Industry	U.S. Labor Market Used in Car Industry

• Note – Land will move from car industry to wheat industry in the U.S.; however, the rental price of land will never return to its pre-trade level, because the U.S. was abundant in land used in wheat industry

7. Chinese car industry expands

• • • Labor migrates from wheat industry to car industry
    • Derived demand – labor supply shifts left in wheat industry
      • Thus, wage rates increase
    • Labor supply shifts right for car industry
      • Thus, wage rates fall
• Note – Capital will move from wheat industry to car industry in China; however, the rental price of machines will never return to its pre-trade level, because the China was abundant in capital used in car industry

Three Implications of Heckscher-Ohlin Theory

1. Real returns to factor resources in the rising price industry experiences higher returns
2. Real returns to factor resources in the falling price industry experiences lower returns
3. Example
   • United States – trade expands the wheat industry
     • Landowners experience higher returns for land
   • China – trade expands the manufacturing industry
     • Capital owners experience higher returns for machines and equipment
4. Equations
   • Purely competitive markets, P = MC
   • P _wheat = ar + bw
   • P _cars = cr + dw
   • r and w are rental and wage rates respectively
   • a, b, c, and d are production coefficients
   • Firm pays for resources that are used to produce one unit of production
5. Pure trade raises the price of wheat
   • A higher price causes the rental rate of land to increase
   • If the price of cars stay the same, then the wage rates must fall
     • Note – free trade would cause the price of cars to fall, thus, causing wages to drop further

1. The more specialized a resource is, the more its factor price rises as the product’s price increases
2. The more specialized a resource is, the more its factor price decreases as the product’s price decreases
3. Examples
   • Land – can only grow rice on the field
     • If trade causes the market price of rice to increase (i.e. exports), then price of land increases
     • If trade causes the market price of rice to decrease (i.e. imports), then price of land decreases
   • Machines that make circuit boards
     • If trade causes price of electronics to increase (i.e. exports), then return on machines increase
     • If market price falls (i.e. imports), then return for machines falls

1. 1. Examples
      • Wage rates for labor should equalize across trade partners
      • Land rental rates for land of comparable quality should equalize
      • Capital rental rates for machines should equalize across trade partners
   2. Why
      • U.S. is land abundant while China is labor abundant
      • Free trade expands U.S. wheat production but contracts China’s
        • Rental rates increase in U.S. but fall in China
        • Remember – abundant land means U.S. had a low-cost advantage
      • Free trade expands car production in China, but contracts U.S.
        • Wage rates increase for Chinese workers and falls for U.S.
        • Remember – large labor force gave China an advantage in car production
   3. Reasons why factor prices may not equalize
      • Countries have different levels of human capital
      • Countries have different levels of technology
      • Transportation costs could keep resource prices from being equal

• Tested Heckscher-Ohlin Theory
• Calculated capital-labor ratios for the United States in 1947
• Theory - U.S. should export capital-intensive goods
• Reality - U.S. imported capital-intensive goods and exported labor-intensive goods
• Aggregation problem – capital and labor are not uniform
  • Many analysis sums labor and capital together
  • Labor is not the same in the same industries and countries
  • Different levels of human capital

1. Some industries follow these theories quite well
   • U.S. – land abundant; thus it exports agricultural industries
     • U.S. has scientists and engineers that leads to exports of high-tech products
   • Japan - not abundant in land, so Japan imports agricultural, fish, forestry, and mineral products
   • Middle East – petroleum abundant; thus, it exports petroleum
   • China and India – labor abundant; they do export labor-intensive products
2. Some industries do not follow theories well
   • China and India also export electronics and computers (high tech)
     • Countries have a bias for high-tech industries
     • Countries have abundant labor to assembly the computers and electronic devices
     • India and China have highly skilled scientists and engineers