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5.12 The Distributive Effects of Free Trade in the Heckscher-Ohlin Model

Learning Objective

  1. Learn how income is redistributed between factors of production when adjusting to free trade.

The term “distributive effects” refers to the distribution of income gains, losses, or both across individuals in the economy. 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. For example, a worker who has deposits in a pension plan that invests in mutual funds has current wage income, but changes in rental rates will affect his or her future capital income. This person’s income stream thus depends on both the return to labor and the return to capital.

For the moment, we shall consider the distributive effects on workers who depend solely on labor income and capitalists who depend solely on capital income. Later we shall consider what happens if individuals receive 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. Increases in nominal income are not sufficient to know whether an individual is better off since the price of exportable goods will also rise when a country moves to free trade. By assessing the change in real income, we can determine how the purchasing power of workers and capitalists is affected by the move to free trade.

Suppose there are two countries, the United States and France, producing two goods, clothing and steel, using two factors, capital and labor, according to an H-O model. Suppose steel production is capital intensive and the United States is capital abundant. This implies that clothing production is labor intensive and France is labor abundant.

If these two countries move from autarky to free trade, then, according to the H-O theorem, the United States will export steel to France and France will export clothing to the United States. Also, the price of each country’s export good will rise relative to each country’s import good. Thus in the United States, PS/PC rises, while in France PC/PS rises.

Next, we apply the magnification effect for prices to each country’s price changes.

In the United States, (PSPC) => PS>PC—that is, if the ratio of prices rises, it must mean that the percentage change in PS is greater than the percentage change in PC. Then applying the magnification effect for prices implies

r>PS>PC>w.

This in turn implies that

rPS, rPC,

which means that the real rent in terms of both steel and clothing rises. And

wPS, wPC,

which means that the real wage in terms of both steel and clothing falls.

Thus individuals in the United States 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.

In France, (PCPS) => PC>PS—that is, the percentage change in PC is greater than the percentage change in PS. Then, according to the magnification effect for prices,

w>PC>PS>r.

This in turn implies that

wPC, wPS,

which means that the real wage in terms of both clothing and steel rises. And

rPC, rPS,

which means that the real rent in terms of both clothing and steel falls.

Thus individuals in France 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 France 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. Trade occurs because of differences in endowments between countries. The United States is assumed to be capital abundant, and when free trade occurs, capitalists in the United States benefit. France is assumed to be labor abundant, and when free trade occurs, workers in France benefit. Thus, in the H-O model, a country’s relatively abundant factor gains from trade, while a country’s relatively scarce factor loses from trade.

It is worth noting that the redistribution of income is between factors of production and not between industries. The H-O model assumes that workers and capital are homogenous and are costlessly mobile between industries. This implies that all workers in the economy receive the same wage and all capital receives the same rent. Thus if workers benefit from trade in the H-O model, it means that all workers in both industries benefit. In contrast to the immobile factor model, one need not be affiliated with the export industry in order to benefit from trade. Similarly, if capital loses from trade, then capitalists suffer losses in both industries. One need not be affiliated with the import industry to suffer losses.

Key Takeaways

  • In the H-O model, when countries implement free trade, output prices, wages, and rents on capital change.
  • If a country is abundant in capital (labor), then a movement to free trade will increase real rents (wages) and decrease real wages (rents). In other words, income is redistributed from workers (capital owners) to capital owners (workers).
  • Because labor and capital are assumed to be homogeneous factors, workers (capital owners) in both industries realize identical real income effects.
  • The redistribution of income in the H-O model is based on which factor an individual owns, not on which industry an individual works in (as it is in the immobile factor model).

Exercises

  1. Consider an H-O economy in which there are two countries (United States and France), two goods (wine and cheese), and two factors (capital and labor).

    1. Suppose France exports wine, the capital-intensive good. Which factor benefits from free trade in the United States? Explain.
    2. Suppose workers in France benefit when tariffs are increased on cheese imports. Which factor is used intensively in cheese production? What is France’s abundant factor? Explain.
  2. Suppose two countries, Malaysia and Thailand, can be described by a variable proportions H-O model. Assume they each produce rice and palm oil using labor and capital as inputs. Suppose Malaysia is capital abundant with respect to Thailand and rice production is labor intensive. Suppose the two countries move from autarky to free trade with each other. In the table below, indicate the effect of free trade on the variables listed in the first column in both Malaysia and Thailand. You do not need to show your work. Use the following notation:

     

    + the variable increases

    the variable decreases

    0 the variable does not change

    A the variable change is ambiguous (i.e., it may rise, it may fall)

Table 5.10 Effects of Free Trade

In Malaysia In Thailand
Price Ratio Ppo/Pr
Real Wage in Terms of Palm Oil
Real Wage in Terms of Rice
Real Rental Rate in Terms of Palm Oil
Real Rental Rate in Terms of Rice