Heckscher-Ohlin model

The Heckscher-Ohlin model (H-O model) is a General equilibrium mathematical model of the macroeconomy in international trade, developed by Eli Heckscher and Bertil Ohlin at the Stockholm School of Economics. It builds on David Ricardo's theory of comparative advantage by predicting the patterns of trade in the types of good that particular countries will specialize in exporting.

Assumptions of the model

The original, 2x2x2 model was derived with restrictive assumptions, partly for the sake of mathematical simplicity. Some of these have been relaxed, in developments. These assumptions and developments are listed here.

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Both countries have identical production technology

As mentioned above, the HO model differs from Ricardo's most drastically by assuming that the production functions available in each country are identical. The production functions simply convert labour and capital input to output.

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This assumption means that producing the same output of either commodity could be done with the same level of capital and labour in either country. Actually, it would be inefficient to actually use the same balance in either country (because of the relative availability of either input factor) but, in principle this would be possible. Another way of saying this is that the per-capita productivity is the same in both countries in the same technology with identical amounts of capital.

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Countries have natural advantages in the production of various commodities in relation to one another, so this is an 'unrealistic' simplification designed to highlight the effect of variable factors. (This meant that the original HO-model produced an alternative explanation for free trade to Ricardo's, rather than a complementary one). In reality, both effects may occur (differences in technology and factor abundances).

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In addition to natural advantages in the production of one sort of output over another (wine vs. rice, say) the infrastructure, education, culture, and 'know-how' of countries differ so dramatically that the idea of identical technologies is a theoretical notion. Ohlin said that the HO-model was a long run model, and that the conditions of industrial production are "everywhere the same" in the long run. (http://www.econ.iastate.edu/classes/econ355/choi/ho.htm).

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Production output must have constant Return to Scale

Both of the countries in the simple HO model produced both commodities, and both technologies have constant returns to scale (CRS). (CRS production has twice the output if both capital and labour inputs are doubled, so the two production functions must be 'homogenous of degree 1').

Related Topics:
Constant returns to scale - Homogenous

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These conditions are required to produce a mathematical equilibrium. With increasing returns to scale it would likely be more efficient for countries to specialize, but specialization is not possible with the Heckscher-Ohlin assumptions.

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The technologies used to produce the two commodities differ

The CRS production functions must differ to make trade worthwhile in this model. For instance if the functions are Cobb-Douglas technologies the parameters applied to the inputs must vary. An example would be:

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: Fishing industry: F = rac{1}{{K}^{1/3}}rac{1}{ {L}^{2/3}}

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: Arable industry: A = rac{1}{sqrt{K}} rac{1}{ sqrt{L}}

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Where A is the output in arable production, F is the output in fish production, and K, L are capital and labour in both cases.

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In this example, the marginal return to an extra unit of capital is higher in the fishing industry, assuming units of F(ish) and A(rrable) output have equal value. The more capital-abundant country may gain by developing its fishing fleet at the expense of it arable farms. Conversely, the workers available in the relatively labour-abundant country can be employed relatively more efficiently in arable farming.

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Labour mobility within countries

Within countries, capital and labour can be reinvested and re-employed to produce different outputs. Like the comparative advantage argument of Ricardo, this is assumed to happen costlessly.

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If the two production technologies are the arable industry and the fishing industry it is assumed that farmers can shift to work as fishermen with no cost, and vice versa.

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Capital mobility within countries

It is further assumed that capital can shift easily into either technology, so that the industrial mix can change without adjustment costs between the two types of production.

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For instance, if the two industries are farming and fishing it is assumed that farms can be sold to pay for the construction of fishing boats with no transaction costs.

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Capital immobility between countries

The basic Heckscher-Ohlin model depends upon the relative availability of capital and labour differing internationally, but if capital can be freely invested anywhere competition (for investment) will make relative abundances identical throughout the world. (Essentially, Free Trade in capital would provide a single worldwide investment pool.) With capital mobility this model would degenerate into autarky.

Related Topics:
Competition - Free Trade - Autarky

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Differences in labour abundance would not produce a difference in relative factor abundance (in relation to mobile capital) because the labour/capital ratio would be identical everywhere. (A large country would receive twice as much investment as a small one, for instance, maximizing capitalist's return on investment).

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As capital controls are reduced, the modern world has begun to look a lot less like the world modelled by Heckscher and Ohlin. It has been argued that capital mobility undermines the case for Free Trade itself, see: Capital Mobility Free Trade critique. Capital is mobile when:

Related Topics:
Free Trade - Capital Mobility Free Trade critique

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• There are limited exchange controls
• Foreign Direct Investment (FDI) is permitted between countries, or foreigners are permitted to invest in the commercial operations of a country through a stock or corporate bond market

Labour immobility between countries

Like capital, labour movements are not permitted in the HO world, since this would drive an equalization of relative abundances of the two production factors, just as in the case of capital immobility above. This condition is more defensible as a description of the modern world than the assumption that capital is confined to a single country.

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Commodities have the same price everywhere

The 2x2x2 model originally placed no barriers to trade, had no tariffs, and no exchange controls (capital was immobile, but repatriation of foreign sales was costless). It was also free of transportation costs between the countries, or any other savings that would favour procuring a local supply.

Related Topics:
Tariff - Exchange control

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If the two countries have separate currencies, this does not affect the model in any way (Purchasing Power Parity applies). Since there are no transaction costs or currency issues the law of one price applies to both commodities, and consumers in either country pay exactly the same price for either good.

Related Topics:
Currencies - Purchasing Power Parity - Law of one price

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In Ohlin's day this assumption was a fairly neutral simplification, but economic changes and econometric research since the 1950s have shown that the local prices of goods tend to be correlated with incomes when both are converted at money prices (although this is less true with traded commodities). See: Penn effect.

Related Topics:
Econometric - 1950s - Penn effect

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Perfect internal competition

Neither labour nor capital has the power to affect prices or factor rates by constraining supply; a state of perfect competition exists.

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