Heckscher Ohlin Theory

Keywords: heckscher ohlin model, factor endowment theory

Heckscher-Ohlin (H/O) theory is also known as factor-endowment theory. . It is a basic model of trade and production. It emphasises the differences in factor endowment between countries are the basis for international trade. The Heckscher-Ohlin model assumes two production factors and an internationally uniform production for each of two industries. Country will export the commodity that use relative intensively its relatively abundant factor of production

Heckscher-Ohlin is given by Elis Heckscher and Bertil Ohlin. Elis Heckscher was a Swedish economic historian developed the modern theory of international trade in 1919. And Heckscher’s student Bertil Ohlin has more clear and overall explanation of the theory. However, he published a book ‘International and Inter-regional’ in 1933. He disagreed the comparative cost of international trade. (Jains, 2009) The comparative cost theory states the difference of comparative cost so the international trade happens. This theory did not explain the reason of ultimately determines comparative advantage. According to David Ricardo, the cause of relative labour productivity, hence relative labour cost and relative product price differed in the two countries before trade. (Carbaugh, 2008). On the other hand, H-O theory is better than comparative advantage to explain observed trade pattern and the effects of political groups on trade. It also shows the impact of economic growth on trade.

Heckscher-Ohlin theory is consists of four central propositions. Firstly, the Heckscher-Ohlin Theorem itself;each nation will export the good which use its abundant factor intensively nad will import the good which its scarce factor intensively. Secondly, the Factor Price Equalization Theorem suggests the free trade in outputs that specialise in labour-intensive production and export the capital-intensive goods. Thirdly, Stolper-Samuelson Theorem states that when the postive how changes in goods prices when changes in factor prices. The price of the abundant will increase more than the increase in the price of the goods which use the abundant factor intensively. As a result, it will increase the wages in the labour abundant country. Forthly, Rybczynski Theorem defined the increase in the factor of production can lead to a shortening in the production of the commodity using that factor intensively and an absolute expansion of the commodity using relatively little of the same factor. (Fisher,2010)

According to Heckscher-Ohlin theory, a country has comparative advantages in those commodities that use its abundant factor intensively. Hence, each country will export the product which uses its abundant factor intensively and will import the product which uses its scarce factor intensively. For that reasons, the labour-abundant countries export labour intensive goods and capital-abundant countries export capital intensive goods. For example, China exports toys and clothes. It has relatively low labour costs. On the other hand, Germany exports cars. The productions of cars need heavy construction equipment and industrial machinery. This is why this theory is also called factor proportions analysis. In accordance with H-O theory, we assume a country’s capital-labour ratio is K/L. For example, we concern the trade between China and US. China has 10 machines and 20 workers. The US has 80 machines and 240 workers. Therefore, Kc/Lc=1/2 and Kus/Lus =1/3. In this example, China is considered as labour abundant country. We suppose K and L have price denoted as rent (R) and Wages (W). If (W/R)us is the Wage/Rent in US and (W/R)c in China. When (W/R)us < (W/R)c, China is considered as labour abundant and US is considered as capital abundant country. The definition of factor intensity concerns the amount of labour and capital required to produce a good as follows: We suppose two goods (A and B) have two factor of production (K and L). Then, we suppose (K/L)A means the capital/Labour ratio require to product one unit of good A; (K/L)B means the capital/Labour ratio require to product one unit of good B. When (K/L)A > (K/L)B, good A is capital intensive and good B is labour intensive. (Clarke and Kulkarni)

H-O Model is two-factor and two-commodity and two-country model. . The basis of trade is the relative cost differentials of commodities as between countries. These cost differences are the same thing as price differences in the classical theroy, as price is equal the marginal cost of the commodity. H-O Model explained these price differences are resulting from differences in factor endowmnet between different countries. Accordingly, differences in factor endowment explain international trade. (Cheriunilam, 2006). For that reason, H-O Model is also called factor proportions analysis. Country specialise capital-intensive goods which will be produced at relatively lower cost and prices. The example of capital intensive good includes textile, shoes and carpets.

In the recent years, China is a significant exportable country due to the labour intensive products. The products largely consisted of toys, clothing and footwear. Indeed, China is the world’s largest exporter. China’s General Administration of Customs (GAC) said that the foreign export reach $130.7bn, rise 17.7% on December in 2010. 2010 World Factbook showed that the population of China is the most in the world. There are 72.1% of population are 15-64 years. The cheap labours, low cost and currency policy improve the production so China is a labour abundant country. According to H-O theory, the responsibly of international trade that bring the equality in the factor price of the countries concerned. The wage rate in China is low so they can specialise the labour intensive goods. On the other hand, the interest rate in Japan is low so they can specialise the capital intensive goods. Thus, China export labour intensive goods to Japan and Japan will export capital intensive goods to China. China will export more labour intensive good, so the demand of labours will increase and the wage rate will also rise. But, China will import more capital intensive good, so the demand of capital decrease, the price of capital will also drop. Likewise, the price of capital will increase and the wage of labour will decrease in Japan. The increase in wage in China will become equal to decrease the wages in Japan. Therefore, the price of the factors will become equal in China and Japan because of international trade. (Jain and Sen, 2008)

There are two ways to prove the H-O theory that the different factor endowment lead to different transaction curves. The first strategy produces the factor proportion version of H-O theory. Therefore, we can prove that the different factor of production prices lead to different price of goods. The second strategy is the trade eliminates difference in factor of the price.

The model of Heckscher-Ohlin is based on a number of explicit and implicit assumption. The important assumption of the model are as the following: First of all, this theory is related to two countries (H and F),two goods (A and B)and two factors (K and L). Hence, it is called 2x2x2 model. (Jains, 2009) This formula also called the Heckscher-Ohlin-Samuelson (HOS) model because Paul Samuelson who develped mathematical model from the H-O model. Moreover, there is no producitivity differences because all the countries use the same technology to produce good A and good B. For that reasons, both countries will give same quantity and quality of output. Furthermore, the preferences of all consumers are identical such as tastes of consumers and expections of future prices. Besides, in the process of production and consumption, there are only two goods are important such as food and cloth. According to a production fuction featuring constant return to scale and diminishing marginal product., food and cloth are used to combine with labour and land. Additionally, there is perfect compective in all market, as no buyer or seller of a commodity has the power to affect the price of the commodity by itself. The prices of the commodities are equal to their marginal productivity because the market for a commodity is also perfect competitive. So, there are many buyers and sellers. But , the number of suppliers are fixed in each country and all resources are fully employed. The factor endowment are different between two countries. Simultaneously, all sellers sell same goods. The goal of individual buy products is to maximize happines wheras the goals of firm sell products is to maximize profit. Although the perfect factor mobility within each country, international factor immobility. There is free trade exists between two countries due to no distribution on the market and transaction cost. (Jain et al, 2008) In additonal, the land-intensive is the production of food. In contrast, the labour-intensive is the production of cloth. As a result, the number of worker is always higher in cloth production than in food production. What’s more, factor intensity differs between goods. That is, some goods are capital intesnive and some goods are labour intensive. It means that labour intensive require relatively more capital for the production and labour intensive require relatively more labour for their production.

However, Wassily W. Leontief attempted to empirically test te validity of the H-O Model in 1953 with the United States trade pattern. Then, Bowen, Leamer and Sveikauskas tested the H-O model on global data to confirm the Leontief Paradox . The Tests on manufacturing data between low or middle income countries and high income countries also support this model. Leontief (1951) builted an input-output model for 200 US industries for 1947. He assumed US was K-abundant country and he used US exports and import substitutes. The data took into account only two factors including labour and capital. It found that US exports tend to more labour-intensive than US imports as US imports are relatively more capital-intensive than US exports. It proved the factor-proportion theory. (Cheriunilam, 2006) The Leontief Paradox pointed out that US workers are more productive than foreign workers.

After that, Leamer (1980) used a multifactor version of H-O Model to conclude the trade patterns and factor were related to each other. Leamer (1984) recognised the role of relative factor endowment in accounting for trading patterns in a multi-country, multi-factor framework. In short, he found that the net export of natural resources such as petroleum and raw materials are positively related to supplies of such natural resources such as coal and oil. As well as, the net export of various harvest is positively related to land endowments and manufactured goods are positively related to capital and labour endowments. Leaner (1984) concluded that ‘the main current of international trade are well understood in terms of the abundance of a remarkably limited list of resources. In that sense the Heckscher-Ohlin theory comes out looking rather well’.

Afterwards, Maskus (1985), Bowen, Leamer and Sveikauskas (BLS) (1987) tried to test the links between endowments and intensities to trade pattern. Their studies used global data to find contradictory result. , BLS (1987) defined the relationship of three variables including trade, factor endowments and factor input requirements in this study “the first systematic and complete evaluation of the relationships implied by the H-O-V Hypothesis among these three sets of variables.” These studies examined 12 factors of production for 27 countries, and under the condition of technological differences to expand the H-O Model. The study found that for two-thirds of the factors of production, trade happened in the direction expected by the H-O Theorem less than 70 percent of the time.

Trefler (1993) investigated 33 countries and 9 inputs; he found that poor countries tend to be abundant in most factors which rich countries tend to be scarce in most factors. It called Endowments Paradox. Rich countries always have trade surpluses. Trefler explained this study more clearly in 1995. He was the first economist to consider a non-factor price equalisation version of H-O model. The three main assumption of factor price equalisation theorem: all countries have the same technology, all countries produce all goods and there are no trade costs. Trefler (1995) indicated the different of cross-country in technology and found that the model preformed much better. John Romalis (2004) loosed the third assumption of factor equalisation theorem and allowed for costly international trade. His study pointed out that countries use their abundant factor intensively to export disproportionate amount in industries.

Harrigan (1995,1997) explained the production of the H-O model is most closely. Harrigan (1997) examined the contribution of TFP and factor abundance in determining specialisation in a series of reduced from industry-level studies. He does not examine the conditions under which the omission of Ricardian technology introduces systematic biases in the test of H-O model. This paper contributes to the literature by delivering a condition under which ignoring one factor for comparative advantage will or will not bias empirical test of the other and finds that this condition hold empirically in the data set examined. (Morrow, 2008)

Nevertheless, H-O model cannot fully explain the international trade. It is a static theory. It only shows the position of factor in a country at any given point of time. But it does not show how the economy will grow with a change in production condition. First of all, H-O theory is unrealistic assumption such as 2x2x2 model. Leontief (1953) challenged H-O theory. The determination of trade refers to relative abundance of factors of production in each country. Haberler criticise that H-O theory is failed to develop comprehensive general equilibrium. It is merely a partial equilibrium analysis. The factors of production are not homogeneous in all countries as the assumption of H-O theory is that the factors of production are homogeneous in trading countries such as production technologies. Wijnholds judged the H-O theory is failed to recognise factor to affect the price of final good. The marginal utility decides the price of goods. Besides, the difference in factor endowment is not only reason of international trade. But, H-O theory ignore other reasons of international trade exists such as difference in the quality of factors. So, H-O theory explains the international trade indistinctly. In fact, the preference of consumers to the product cannot be identical while the preferences of consumers are equal in H-O theory. In conclude, H-O theory is important theory to the international trade. (Jain et al, 2008)