Ricardian and Heckscher-Ohlin Models of International Trade

Subject: Economics
Pages: 6
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This piece of essay contains discussions about the following: Rucardian model of international trade, assumptions of the model, and the model’s view of the gains from free trade and the determinants of the relative extent of the gains. Discuss about Heckscher-Ohlin model of trade, assumptions of the model, what determines the pattern of trade according to the theory, explanation on the tendency of wage to equalize and the conditions that could falsify either both of the conclusions, discussion about real income effects of tariff imposition, resource allocation, consumer well being and an explicit argument against free trade.

Ricardian model of international trade

In 1816, Ricardo developed a model that was named after him. This model was based on the idea of comparative advantage. Up to date, many countries apply this concept in formulating international trade strategies. Ricardo’s comparative advantage model, pictures a world of two countries, C and D, each employing a single factor of production, labor, in production of goods M and N. the main comparison is on the relative costs of producing either of the two products, by the two countries. The model was constructed on these assumptions:

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  • Two countries are occupied in trade ,that is, D and C
  • The commodities produced are only two, that is, M and N.
  • There is only one existing factor of production, labor.
  • There is perfect competition in both of the two countries.
  • There is homogeneity in labor supply but with different levels of production in the trading countries.
  • The goods produced are homogenous.

According to the model, the countries produce a good that is less costly. That is, the good that is comparatively cheap to produce, with constant amount of factor input. Considering the assumption that there exist a perfect competition, supply is subject to perfect competition and this means that profit making, within the countries, is not possible. Real wages in autarky are determined by the productivity level of the countries. Low wage countries have low productivity level, that is, wages increase with productivity.

One of the gains from free trade, according to the model, is increased specialization of the trading countries. If one country has resources that facilitate cheaper production of a commodity, then it will ensure that the demand for the product in the two countries is met. Production of a particular good for a long time leads to specialization. Specialization develops skills and increases the quality and the scale of production. The model clearly states that a country produces a comparatively cheaper product. This enables the separation of production and demand decisions. Consumer decision can be stated as a factor that determines the relative extent of the gains. Another determinant of the extent of the gains is factors of production. Constant resource availability will influence stability of levels of production. Fluctuating availability of resources limits the extent of specializing on a product.

The Heckscher-Ohlin model

The Heckscher-Ohlin model of trade is reliant on factor- proportion comparative advantage. Heckscher contends that returns of international commerce are based on the geographical distribution of productive resources. The theorem is based on the notion that when trade occurs, country A with abundant factor of production C, exports C-intensive product to the foreign country whereas, the country B with abundant factor D, exports D-intensive products. In other words, both countries export the commodity that exhaustively uses the resource that is plentiful in each.

The Heckscher-Ohlin’s model is base on the following assumptions:

  • All markets are perfectly competitive- no buyer or seller of a commodity has the power to solely, affect the price of the commodity. The market for a commodity is perfectly competitive if there are many sellers, many buyers and homogenous products.
  • Individuals make decisions to minimize happiness.
  • Firms make decisions to maximize profits.
  • Governments do not interfere with the smooth functioning of markets, that is, there are no taxes, tariffs, quotas and subsidies.
  • There is free trade in goods and services but there is no cross border movement of resources such as labor.
  • Technological knowledge is the same in both countries.
  • The technology used in production satisfies constant return to scale, that is, if a commodity producer doubles the amount of resources used, then the amount produced will increase twice.
  • Home country has a higher ratio of labor to capital than foreign country does, that is, if Kh, Kf, Lh and Lf denote the amounts of K(capital) and L(labor) that home and foreign are endowed with, then Lh/Kh>Lf/Kf.
  • The production of food is capital-intensive and the production of cloth is labor intensive, that is, the number of workers per machine (L/K) is always higher in cloth production than in food production.

Determinants of pattern of trade

During autarky, a labor-intensive good is relatively cheaper in the labor-abundant country whereas, capital -intensive good is relatively cheaper in the capital- abundant country. Consequently, under free trade, labor-intensive commodities are exported by labor-abundant country and those that are capital-intensive are exported by country with plenty of capital. In other words, when trading occurs, the country with plenty of labor exports the labor-intensive good and the country with plenty of capital exports the capital-intensive good. In general, trade between the two countries is relying on the idea that, the countries will export the commodities that intensively use the resource that is plentiful in that country.

Equalization of wage and rent rates

During autarky, the ratio of wage /rent is high in the country with low labors supply and low in the country with high supply of labor, that is, wage rates are high in the country with high supply of labor and low in the country with high supply of labor. On the other hand, during free trade, the wage-rent ratio falls in the labor-scarce country and rises in labor-abundant country, that is, wage rates falls as the rent (profit) increases in labor-scarce country and rises in labor- abundant country. Thus under free trade, profitability levels are high in labor-scarce countries and low in labor-intensive countries.

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In both cases, the situations could be falsified. For example, in labor-intensive country, wage rates are high and on the contrary, profits from labor-intensive products are low. Consider a labor-intensive country without qualifications to limit a section of unskilled laborers; everybody would be qualified to perform any task. The demand for employment would be higher than the employment rates. This situation lowers the wage rates instead of increasing as opposed to a skilled labor-intensive market situation.

Tariff and real income

Tariff is a tax imposed on goods that are brought into a country from a broad (imports). The main purpose for imposing a tariff is to restrict the flow of foreign products into a country. Tariff increases the cost of importation and thus the cost of the imported products. The imported goods therefore become expensive compared to the local products. There sales level will reduce and eventually, the products could fall out of the market. Tariffs could be used by a country’s Government to protect newly introduced local products from stiff competition. A small country is that which is still in its early development stage. A developing country needs to tap all sources of income and use them to finance its development activities. Real income is that which has been adjusted for changes in values of inflation and a countries purchasing power.

If a small country imposes a tariff, there will be fewer imports. This will reduce the competition between local and imported goods. The local companies will dominate the local market and be reluctant. The reluctance will create under exploitation of resources and available skills. As a result, there will be inefficient resource allocation. Resources can only be efficiently allocated to specific production areas in the presence of an active competition for customers in the market. Lack of efficient resource allocation causes underutilization. Underutilization means failure of deployment of resources to there maximum potential usage. Inactive market provides low quality products to the customers and at the same time provides no varieties. Consumer sovereignty is undermined and so is there well being.

A quota is a restriction that is imposed by the Government of a country to control the extent of importing goods and services into a country during a particular period. Quotas allow foreign products in a country and therefore, stimulate competition in a local market. Tariff eliminates competition whereas, quotas allow for it but in small dosage. Therefore, under quotas, there is efficiency in resource allocation. In addition, utility of resources is maintained at a good level. Subsidy is a governmental undertaking to stimulate the performance of particular economic sectors. In most instances, it is in form of cash handout and/ or tax reduction. Subsidies also help stimulate efficient allocation of resources and improve the utility levels of the resources. Since it stimulates a country’s economic performance, it improves the consumers’ well being.

Arguments against free trade

Jobs security within a country: it is beneficial to engage in free trade. It is also beneficial to export an abundance resource to countries experiencing the same. Nevertheless, some countries have different opinion on skills and job exportation. Job exportation renders the industrial situation in the home country inefficiently operational.

Currency stability: if a country imports more than it exports, its balance of payment will run a deficit. More imports will increase the demand of a foreign currency and supply more than needed, of its own currency, in the market. The countries currency value will decrease. The purchasing power of the country will be reduced. Therefore, to maintain the stability of the currency value, free trade is not the way.

Protection of Young industries: companies are one of a country’s economic drives. Free trade exposes all companies to stiff and unfair competition. For a young company to survive in a market, it should be protected from stiff market competition. In a bid to protect these young companies, a country will have to restrict its activities in a free trade.

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Diversification: it is not a safe economic strategy to rely only on a single economic activity. Countries need to have different economic activities to facilitate their growth plan. It will also help in protecting a country against some exposures like price fluctuations, currency rates fluctuations and commodity risks.