The Heckscher-Ohlin (H-O) model with physical capital

The H-O model is also known as the 2X2X2 Model because there are 2 countries (US, Them), 2 products (food, cloth), & 2 factors of production (L & K).

Different products require different amounts of capital (land) per worker:

Production/dayInputs requiredInputs required 
1 Cloth1/2 Worker/day1/4 acre landCloth is labor intensive because it requires 2 workers/acre
1 Food1/4 Worker/day1/2 acres landFood is capital intensive because it requires 2 acres/worker

Different countries have different amounts of capital (land) per worker:

Countries# of workersLand (acres)Max. cloth output
(if no food is produced)
Max. food output
(if no cloth is produced)
Cloth output
w/o unemployed factors
Food output
w/o unemployed factors
  (+1 owner)
(½ acres unemployed)
(2 workers unemployed)
  (+1 owner)
(2 acres unemployed)
(½ workers unemployed)

Owners never work in this economy because they have capital that makes plenty of income for them.

The US is capital abundant because we have 1.5 acres/worker and we are labor scarce because there is only 2/3 of a worker per acre.

THEM is labor abundant because they have 1.5 workers/acre and capital scarce because there is only 2/3 of an acre per worker.

Note that there is one person in each country who doesn’t need to work because he owns all the land. This level of inequality may seem unrealistic, but it isn’t too different from the real world. According to the Credit Suisse Wealth Report 2022, in most capitalist nations, the wealthiest 1% owns about as much of the national wealth as the bottom 99%. The poorest half of the population typically has less than 1 percent of total wealth. You may have thought that inequality is not that extreme because you have probably mostly heard about income inequality which is much less extreme. Wealth inequality is much higher than income inequality because most households earn most of their income from working rather than from owning stuff, but the wealthiest 1% can have a much richer lifestyle than the median wage earner even without working at all. Some of the wealthiest 1% work because they enjoy what they do to make money, but work is a hobby for the wealthy elite.

And it may seem odd to have a model economy where someone doesn’t work at all, but in fact, there has probably never been any time in American history when a majority of Americans were employed (for pay) because the majority of Americans have always been either stay-at-home parents, children, students, retired, unemployed, disabled, imprisoned, and/or part the leisure class who does not work:

Is the US richer or is THEM richer? The US is the richer nation than THEM because the US has one acre of land per person and THEM has only ½ acre of land per person. So the US is twice as wealthy as THEM because land is the only form of wealth in this model and all workers are equally productive.

CountriesPrice of a cloth in AutarkyPrice of a food in AutarkySpecialize and exportChange in Food Price after tradeChange in Cloth Price after trade
THEM¼ foods4 clothsFoods↓P↑P
US4 foods¼ clothsCloths↑P↓P

After trade, the price of food equals the price of cloth because the combined production of food and cloth are equal: 1food=1cloth. In autarky, food was expensive for THEM because THEM produces a lot of cloth and very little food. The scenario is the mirror opposite in the US. After trade, the price is the same everywhere.

THEM specializes in exporting cloth because cloth is labor intensive and THEM is labor abundant.

US specializes in exporting foods because food is capital intensive and US is capital abundant.

  • In the Ricardian model, different labor productivity determined opportunity costs and what each nation exports. In the H-O model, it is the different amounts of resources (capital) in each nation that determines costs and comparative advantage.

After trade, the price of Cloth goes up in THEM and the price of Food goes up in the US. That causes the wages of workers to rise in the country that exports cloth (THEM) because cloth is labor intensive, and exporting cloth increases its value. Similarly, rent payments to capital owners rise in the capital-abundant nation (US) because of increased demand for food which is capital-intensive.

THEM Owner’s rents$90/acre *2=$180 total$75/acre *2=$150 total
THEM Workers’ wages$60/person*3=$180 total$75/person*3=$225 total
US Owner’s rents$60/acre *3=$180 total$75/acre *3=$225 total
US Workers’ wages$90/person*2=$180 total$75/person*2=$150 total

Remember that there is one rich person in each country who owns all the capital (the land) and he doesn’t need to work. In autarky, the laborers split the output with the capital owner in which means that workers in labor-scarce US get a higher income per person than in labor abundant THEM. After trade, the workers in both nations get the same amount of pay which gives a raise to THEM workers, but a pay cut for US workers. There is a symmetric effect for the rents of land. These changes in factor prices raises inequality in the US and decreases inequality in THEM.

THEM Owner income$180 (=3X THEM wage)$150 (=2X THEM wage)↓ Inequality
THEM Workers’ wages$60/person$75/person
US Owner income$180 (=2X US wage)$225 (=3X US wage)↑ Inequality
US Workers’ wages$90/person$75/person

Why does trade hurt US workers’ wages? Because workers are scarce relative to capital in the US, that makes workers valuable relative to capital in autarky, but with free trade, US workers have to compete with THEM where workers are abundant. Nations with abundant labor and scarce capital had lower wages in autarky and trade raises their wages, but hurts US wages. After trade, if there were perfect competition, everyone in the world would make exactly the same wage. Of course the real world IS NOT perfect competition, so this has not happened, BUT trade has certainly caused wages to fall in labor-intensive industries in rich nations. Most US workers switched jobs and do not try to compete with low-wage unskilled workers who export their products to Walmart.

The US is capital abundant compared with poor countries, but not at the top of the world.

Remember that physical capital is a form of wealth. So by the definition of “wealthy,” wealthy countries have a lot of capital per person and poor countries do not. And countries with a lot of capital also tend to have higher wages because capital makes workers more productive and increases the demand for workers.

This is the (1992) data for the preceding graph.

 CountryWageK/L CountryWageK/L
Sri Lanka$0.40$8,395 UK$14.29$22,509
Mexico$2.16$13,697 US$15.52$35,933
Poland$2.89$11,811 Japan$16.13$41,286
Hong Kong$3.91$14,039 France$17.31$37,460
Portugal$4.88$13,493 Canada$17.57$44,970
Taiwan$5.12$30,708 Italy$18.91$33,775
Korea$5.21$17,995 Netherlands$20.01$34,084
Greece$7.66$23,738 Finland$20.06$47,498
New Zealand$8.05$35,359 Austria$20.23$36,641
Israel$8.11$21,618 Belgium$20.51$39,416
Australia$13.23$38,729 Denmark$20.55$33,814
Ireland$13.25$22,171 Norway$23.48$47,118
Spain$13.39$30,888 Germany$23.89$41,115

Predictions of the H-O model

1. Factor-price equalization theorem:

Trade will cause wages to fall in rich countries and rise in poor countries and if there is perfect competition, they become equal around the world. Similarly, the incomes of owners will rise in rich nations and fall in poor countries until capital payments equalize. Capital earnings may not fit the H-O model very well because capital has always been fairly mobile so owners can move it to wherever the earnings are highest, so this does not fit with the model which assumes immobile factors of production.

But labor is relatively immobile and here we have seen evidence that international trade has suppressed the wages of low-education workers in rich nations.

2. The H-O Theorem:

Capital-rich nations will export capital-intensive goods and labor-abundant nations will export labor-intensive goods.

The US is capital abundant, so why does the US mostly export labor-intensive products?

This is sometimes known as the Leontief Paradox and some economists cite this fact as evidence that the Heckscher-Ohlin model is wrong, but if you look at the kind of labor-intensive products the US exports, you will see that everything makes sense. The US exports a lot of

  • Financial services (Wall-Street investment banking & insurance)
  • Entertainment goods (movies, video games, etc.)
  • Software
  • Engineering & design
  • Educational services
  • Advertising
  • Etc.

These exports mostly require more labor than capital, but they also require highly-skilled labor. The US has a comparative advantage in exporting skilled-labor-intensive goods. (Economists often say that “human capital” is skilled labor, and the US is very abundant in human capital relative to the average of the rest of the world.)

The US was very capital abundant relative to the world in 1993 at 2.8% of capital/2.6% of unskilled labor, but the US was also very rich in human capital (“Skilled Labor) at 19.4% of the global total.

Another possible explanation for the Leontief Paradox is the fact that different countries have different kinds of technologies and it is possible that the technologies that are abundant in the US are complementary with US labor.

Different kinds of technologies also can help explain why wages are not the same everywhere in the world:

Manufacturing Hourly Wages & Benefits (2004)

EU – 15$27.17

One of the “technologies” that causes different wages in different countries is education! Countries with better average education typically have higher wages. Germany has had the highest manufacturing wages in the world partly because of having an excellent system for educating manufacturing workers. Another reason wages differ is unionization. Germany is much more unionized than the US and that means that workers get higher wages there and company owners get lower incomes relative to the US. German CEOs and shareholders earn a smaller piece of the pie compared with American CEOs and shareholders.

2. The Rybczynski Theorem

When a country’s capital/labor ratio changes, that will also change the ratio of production of capital-intensive goods to labor-intensive goods. For example, as countries get richer, they tend to produce more capital-intensive goods and less labor-intensive goods. Similarly, if a country would get a large influx of labor (without an change in capital), it will produce more labor-intensive goods and less capital-intensive goods.

This also helps explain the “cost-disease of services”. As the US has gotten more capital-intensive over the past two centuries, we are producing a lot more capital-intensive goods relative to services, BUT the price of capital-intensive goods has plummeted relative to the price of services so that today a service like a symphony concert is very expensive relative to manufactured goods like hammers and wheelbarrows. Two centuries ago, a symphony concert was relatively cheap relative to the cost of a hammer.

3. The Stolper-Samuelson (“class warfare”) Theorem

Says that trade will increase inequality in rich nations and decrease inequality in poor nations. See the last table with US and THEM, above.