Question

(10 marks)

Suppose there exist 2 countries, Home and Foreign; 2 goods, X and Y; and 2 factors of production, labour (L) and capital (K). Each country can produce both goods. X is labour-intensive and Y is capital-intensive. Home is labour-abundant and Foreign is capital-abundant. Assume that the standard assumptions of the Heckscher-Ohlin model hold. When answering the following question, please support each of your arguments with detailed analysis and draw the relevant diagrams to support your answer.

Consider a move from autarky to free trade between the two countries in both goods. Identify which group of people (labourers or owners of capital) gain and which lose in Home from the move from autarky to free trade. Discuss clearly how the assumptions of the model lead to this result.

Answer 1

The Heckscher-Ohlin model is an economic theory that proposes that countries exportwhat they can most efficiently and plentifully produce. Also referred to as the H-O model or 2x2x2 model, it's used to evaluate trade and, more specifically, the equilibrium of trade between two countries that have varying specialties and natural resources.

The model emphasizes the export of goods requiring factors of production that a country has in abundance. It also emphasizes the import of goods that a nation cannot produce as efficiently. It takes the position that countries should ideally export materials and resources of which they have an excess, while proportionately importing those resources they need.

Assumptions of the Heckscher Ohlin Model

• There are two countries
• There are two factors – capital and labor.
• Countries have similar production technology.
• Prices are the same everywhere.
• The tastes in the two countries are identical.
• The two countries have different relative factor endowments namely capital, land and labor. Based on the relative factor endowments, countries are classified as capital abundant, labor abundant or land abundant.
• Factor Intensities may vary.
• Perfect Competition.
• There are no transport costs and no hindrances in trade.
• There are no trade restrictions between the two countries.

Commodity 4 CA CB commodity A

In the Heckscher-Ohlin (H-O) model, there are only two distinct groups of individuals: those who earn their income from labor (workers) and those who earn their income from capital (capitalists). In actuality, many individuals may earn income from both sources.

To measure gains or losses to workers and capitalists, we must evaluate the effects of free trade on their real incomes. If these two countries move from autarky to free trade, then, according to the H-O theorem, the country A will export Commodit X to Foreign country and Foreign country will export commodity Y to the Home coutry. Also, the price of each country’s export good will rise relative to each country’s import good.

Thus individuals in the Foreign country who receive income solely from capital are able to purchase more of each good in free trade relative to autarky. Capitalists are made absolutely better off from free trade. Individuals who receive wage income only are able to purchase less of each good in free trade relative to autarky. Workers are made absolutely worse off from free trade.

Thus individuals in Home country who receive wage income only are able to purchase more of each good in free trade relative to autarky. Workers are made absolutely better off from free trade. Individuals in home coutry who receive income solely from capital are able to purchase less of each good in free trade relative to autarky. Capitalists are made absolutely worse off from free trade.

These results imply that both countries will experience a redistribution of income when moving from autarky to free trade. Some individuals will gain from trade, while others will lose. Distinguishing the winners and losers more generally can be done by referring to the fundamental basis for trade in the model.