International Economics

Lecture 4: Leontief Paradox and

Complementary Trade Theories
 Predictions of the Hecksher-Ohlin
model
1. A country will export goods that are intensive in using
abundant factor inputs
• Example 1: Home country is abundant in labour, and
production of X uses labour intensively – so Home exports X
• Example 2: Foreign country is abundant in capital/machines,
and production of Y uses capital intensively – so Foreign
exports Y
• If a country is labour (capital) abundant, it will export
(capital) labour intensive goods
2. For Home country, if price of x increases (production
of x uses labour intensively, and labour is abundant in
Home), labour will enjoy higher income while other
factor inputs will suffer [Stolper-Samuelson theorem]
 Predictions of the Hecksher-Ohlin
model
3. If a factor input increases in supply, the production
of the good which uses that factor input
intensively, will increase as well, while the
production of other goods will fall [Rybczynski
theorem]
• Example 1: production of x uses labour intensively, so if
labour supply rises, x will rise as well
• Example 2: production of y uses capital intensively, so if
capital supply rises, y will rise as well
4. If free trade allowed between countries, not only
good prices converge, but factor prices also
converge [Factor price equalisation theorem]
 How well does Hecksher-Ohlin work in
practice?
• Wassily Leontief (1905-1999): Made a study to
test the validity of the H-O model (see Leontief
(1953), ‘Domestic production and foreign trade:
the American capital position re-examined’,
Proceedings of the American Philosophical
Society, volume XCVII, pages 332-349)
• This was the first serious study on the H-O model
How well does Hecksher-Ohlin work in
practice?
• Based on prediction 1. of H-O, if country is
capital abundant, it will export capital abundant
goods.
• US was considered as capital abundant in the
1940s and 1950s. Although capital abundant,
Leontief’s findings show that US was exporting
labour-intensive goods instead – a
violation/contradiction of the predictions of H-O
• H-O theory wrong? This strange finding became
known as Leontief’s paradox
 How do we explain the paradox?
• Leontief’s study takes account of only 1 type of
labour. In fact, there are skilled and unskilled
labour within the pool of workers in US (e.g. of
skilled labour: scientists and engineers)
• Keesing (1966) and Baldwin (1971) found that US
was abundant in skilled labour and exported
skilled labour intensive goods, while importing
capital intensive goods – this was consistent with
predictions of H-O
 How do we explain the paradox?
• Leontief also failed to take account of natural
resources as a factor input. US imports were
found to be capital intensive in Leontief’s
study.
• But in fact the imports were natural resource
intensive.
• Since US was relatively scarce in natural
resources, the finding that US imported
natural resource intensive imports is again
consistent with H-O’s predictions
 How do we explain the paradox?
• Problem of demand reversal
• One assumption in H-O is that demand/consumer
preferences/tastes are identical or at least fairly
similar for trading countries
• If demand patterns are very different, there may
not be trade at all, or a labour abundant country
may not export labour intensive goods (you are
required to prove this result using the diagram
learned in lecture)
 How do we explain the paradox?
• Problem of factor intensity reversal
• One assumption in H-O is that in both Home and
Foreign country, x is labour intensive and y is capital
intensive, i.e. in both countries, the goods use same
technology
• What if x is labour intensive and y is capital intensive
in Home, but in Foreign country it is the reverse? (i.e.
x: capital intensive but y: labour intensive)
• H-O predicts that foreign will export x (capital
intensive good) and import y (labour intensive good)
 How do we explain the paradox?
• Tariff structures
• Based on the predictions of Stolper-Samuelson theorem,
the relatively scarce factor input will suffer from trade.
• For capital abundant country like US, opening up to trade
will cause capital intensive good prices to rise and labour
intensive good prices to fall, labour suffer from lower
income
• Pressure on US government to impose import taxes to
protect labour by preventing prices of labour intensive
goods to fall. Since labour intensive imports remain
expensive, then capital intensive imports were used instead
 A complementary trade theory:
Specific factor model
• H-O assumes that it is possible to change both
labour and capital to affect production and
trade. H-O deals with long-run scenario
• In short-run, capital is fixed (recall year 1
microeconomics!!!)
• If capital is fixed, how do we tell a story to
justify trade between countries? This problem
is remedied by the Specific factor model (see
in class presentation of the model)
 Questions for Tutorial 2
(1) If a country’s comparative advantage lies in capital intensive goods,
then trade will benefit workers but make machine owners worse off.
True/False? Explain your answer
(2) A natural disaster that lowers capital stock in a country also lowers
output in all sectors. True/false? Explain your answer
(3) In the previous lecture and tutorial, a diagram on international trade
was drawn based on two production possibility frontiers.
i. Show graphically that sufficiently different tastes in the two
countries could neutralise the difference in their factor
endowments and lead to equal relative product prices in the two
countries in the absence of trade
ii. Show that the predictions of the Hecksher-Ohlin model holds even
if some differences in tastes exist between Home and Foreign
Country
 Questions for Tutorial 2
US UK
Wheat (bushels/hour) 4 1
Cloth (yards/hour) 3 2

(4) This question is based on the Table above. Assume

that the no-trade point is 3W and 9C/4 in the US and
1W/2 and 1C for UK. Assume with the opening of
trade the US exchanges 1W for 1C with the UK. Show
graphically for both US and UK, the no-trade point of
production and consumption, the point of
production and consumption with trade and gains
from trade
 Questions for Tutorial 2
(5) (a) Refer to the diagram on relative prices and
demand-supply curves for wheat and cloth,
drawn during the previous lectures. What
would be the equilibrium relative prices if
Demand for wheat shifted up by one-third?
How much wheat and cloth would US and UK
produce?
(b) What does the answer to part (a) imply for
the demand for cloth?