How Trade Affects Factor Prices in the Heckscher-Ohlin Model

Summary

The video explores how international trade affects factor prices, focusing on the U.S. and Mexico. The U.S., being capital abundant, exports capital-intensive goods like laptops, while Mexico, labor abundant, exports labor-intensive goods like shoes. As trade opens, wages in the U.S. decrease due to increased labor supply and reduced demand, while wages in Mexico rise due to heightened labor demand. This dynamic leads to a convergence in wages and real interest rates between the two countries, illustrating the Factor Price Equalization Theorem, which posits that trade can equalize factor prices across nations.

Takeaways

• 😀 The US is capital abundant, while Mexico is labor abundant.
• 😀 Wages in the US are initially higher than in Mexico, but real interest rates are higher in Mexico.
• 😀 Laptops are capital-intensive goods, requiring more capital than labor to produce.
• 😀 Shoes are labor-intensive goods, needing more labor than capital in production.
• 😀 When trade begins, the US exports laptops and imports shoes; Mexico does the opposite.
• 😀 In the US, increased laptop production slightly raises labor demand but frees up much labor, leading to falling wages.
• 😀 Conversely, the rising demand for capital in the US significantly increases real interest rates.
• 😀 In Mexico, the expanding shoe industry greatly increases labor demand, resulting in rising wages.
• 😀 The declining laptop industry in Mexico leads to increased capital supply, causing real interest rates to fall.
• 😀 The factor price equalization theorem predicts that trade will narrow the wage and interest rate gaps between countries.

Q & A

What is the Heckscher-Ohlin model?

The Heckscher-Ohlin model is an economic theory that explains how countries trade based on their factor endowments, specifically their relative abundance of capital and labor.

How do factor endowments differ between the US and Mexico in the example?

In the example, the US is described as a capital abundant country, while Mexico is considered labor abundant.

What types of goods do the US and Mexico produce?

The US produces laptops (capital-intensive goods) and shoes (labor-intensive goods), while Mexico primarily focuses on producing shoes and laptops as well.

What happens to wages in the US when trade is opened?

When trade is opened, wages in the US fall due to an increase in the supply of labor from the shrinking shoe industry, while demand for labor increases only slightly.

What effect does the increase in laptop production have on the demand for capital in the US?

The increase in laptop production significantly raises the demand for capital in the US, leading to an increase in the real interest rate.

What occurs in Mexico's labor market as a result of expanded shoe production?

In Mexico, the expansion of shoe production increases the demand for labor, resulting in rising wages, as the supply of labor only increases slightly.

What is the impact on the real interest rate in Mexico after trade begins?

The real interest rate in Mexico falls due to an increase in the supply of capital from the contracting laptop industry, coupled with only a small increase in demand for capital.

How does international trade affect the gap between wages in the US and Mexico?

International trade reduces the wage gap between the US and Mexico, as wages in the US fall while they rise in Mexico, moving toward equality.

What is the factor price equalization theorem?

The factor price equalization theorem states that free trade will equalize factor prices, such as wages and interest rates, across countries due to changes in demand and supply of factors.

What are the long-term implications of trade on factor prices according to the transcript?

In the long term, trade equalizes wages and interest rates across countries by increasing returns on abundant factors and decreasing returns on scarce factors.