Hecksher-Ohlin Model and its Variations - Assignment Example

First of all it's necessary to consider Hecksher and Ohlin theory. The Heckscher-Ohlin model H-O model) is a general equilibrium mathematical model of 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 patterns of trade and production based on the factor endowments of a trading region. The model essentially says that countries will export products that utilize their abundant factor(s) of production and import products that utilize the countries' scarce factor(s). Relative endowments of the factors of production (land, labor, and capital) determine a country's comparative advantage. Countries have comparative advantage in those goods for which the required factors of production are relatively abundant. This is because the prices of goods are ultimately determined by the prices of their inputs. Goods that require inputs that are locally abundant will be cheaper to produce than those goods that require inputs that are locally scarce. For example, a country where capital and land are abundant but labor is scarce will have comparative advantage in goods that require lots of capital and land, but little labor - grains, for example. Since capital and land are abundant, their prices will be low. Those low prices will ensure that the price of the grain that they are used to produce will also be low - and thus attractive for both local consumption and export. Labor intensive goods on the other hand will be very expensive to produce since labor is scarce and its price is high. Therefore, the country is better off importing those goo Theoretical development of the model The Ricardian model of comparative advantage has trade ultimately motivated by differences in labour productivity using different technologies. Heckscher and Ohlin didn't require production technology to vary between countries, so (in the interests of simplicity) the H-O model has identical production technology everywhere. Ricardo considered a single factor of production (labour) and would not have been able to produce comparative advantage without technological differences between countries (all nations would become autarkies at various stages of development, with no reason to trade with each other). The H-O model removed technology variations but introduced variable capital endowments, recreating endogenously the inter-country variation of labour productivity that Ricardo had imposed exogenously. With international variations in the capital endowment (i.e. infrastructure) and goods requiring different factor proportions, Ricardo's comparative advantage emerges as a profit-maximizing solution of capitalist's choices from within the model's equations. (The decision capital owners are faced with is between investments in differing production technologies: The H-O model assumes capital is privately held.) Original publication Bertil Ohlin published the book which first explained the theory in 1933. Although he wrote the book alone, Heckscher was credited as co-developer of the model, because of his earlier work on the problem, and because many of the ideas in the final model came from Ohlin's doctoral thesis, supervised by Heckscher. Interregional and International Trade itself was verbose, rather than being pared down to the mathematical, and appealed because of its new insights. [edit] The 2x2x2 model The original H-O model assumed that the only difference between countries was the relative abundances of labour and capital. The original Heckscher-Ohlin model contained two countries, and had two commodities that could be produced. Since there are two (homogeneous) factors of production this model is sometimes called the "222 model". The model has variable factor proportions between countries: Highly developed countries have a comparatively high ratio of capital to labour in relation to developing countries. This makes the developed country capital-abundant relative to the developing nation, and the developing nation labour-abundant in relation to the developed country. With this single difference, Ohlin was able to discuss the new mechanism of comparative advantage, using just two goods and two technologies to produce them. (One technology would be a capital intensive industry, the other a labour intensive business - see "assumptions" below) 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: Fishing industry: Arable industry: 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. 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(rable) 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. But after analyzing the economic data of the USA it in 1947 was proved that the country tended to export labor intensive goods and to import capital intensive ones. This event was named the paradox of Leontief. Leontief's paradox 2in economics was the result of Professor Wassily W. Leontief's attempt to test the Heckscher-Ohlin theory. In 1954, Leontief found that the U.S. (the most capital-abundant country in the world by any criteria) exported labor-intensive commodities and imported capital-intensive commodities, in contradiction with Heckscher-Ohlin theory ("H-O theory"). To use the economic sittuation in USA he used mathematic method . also known as input-output model. Input-output model3 of economics uses a matrix representation of a nation's (or a region's) economy to predict the effect of changes in one industry on others and by consumers, government, and foreign suppliers on the economy. The inimitable book by Leontief himself remains the best exposition of input-output analysis. See bibliography. Input-output concepts are simple. Consider the production of the ith sector. We may isolate (1) the quantity of that production that goes to final demand, ci, (2) to total output, xi, and (3) flows xij from that industry to other industries. We may write a transactions tableau Table: Transactions in a Three Sector Economy Economic Activities Inputs to Agriculture Inputs to Manufacturing Inputs to Transport Final Demand Total Output Agriculture 5 15 2 68 90 Manufacturing 10 20 10 40 80 Transportation 10 15 5 0 30 Labor 25 30 5 0 60 or Note that in the example given we have no input flows from the industries to 'Labor'. We know very little about production functions because all we have are numbers representing transactions in a particular instance (single points on the production functions): The neoclassical production function is an explicit function Q = f(K,L), where Q = Quantity, K = Capital, L = Labor, and the partial derivatives () are the demand schedules for input factors. Leontief, the innovator of input-output analysis, uses a special production function which depends linearly on the total output variables xi. Using Leontief coefficients aij, we may manipulate our transactions information into what is known as an input-output table: or Now gives Rewriting finally yields Introducing matrix notation, we can see how a solution may be obtained. Let denote the total output vector, the final demand vector, the unit matrix and the input-output matrix, respectively. Then: For many economists, Leontief's paradox undermined the validity of the H-O theory, which predicted that trade patterns would be based on countries' comparative advantage in certain factors of production (such as capital and labor). Many economists have dismissed the H-O theory in favor of a more Ricardian model where technological differences determine comparative advantage. These economists argue that the U.S. has an advantage in highly skilled labor more so than capital. This can be seen as viewing "capital" more broadly, to include human capital. Using this definition, the exports of the U.S. are very (human) capital-intensive, and not particularly intensive in (unskilled) labor. Some explanations for the paradox dismiss the importance of comparative advantage as a determinant of trade. For instance, the Linder hypothesis states that demand plays a more important role than comparative advantage as a determinant of trade--with the hypothesis that countries which share similar demands will be more likely to trade. For instance, both the U.S. and Germany are developed countries with a significant demand for cars, so both have large automotive industries. Rather than one country dominating the industry with a comparative advantage, both countries trade different brands of cars between them. Similarly, New Trade Theory argues that factors other than endowments determine trade. So to my mind the Leontief theory seems to be more realistic and useful for our life. Sources. 1.http://en.wikipedia.org/wiki/Heckscher-Ohlin_model 2http://en.wikipedia.org/wiki/Leontief_paradox 3http://en.wikipedia.org/wiki/Input-output_analysis Read More