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Introduction

  • The classical comparative cost theory did not satisfactorily explain why comparative costs of producing various commodities differ as between different countries
  • The new theory propounded by Heckscher and Ohlin went deeper into the underlying forces which cause differences in compara­tive costs.
  • They explained that it is differences in factor endowments of different countries and different factor-proportions needed for producing different commodities that account for difference in comparative costs. This new theory is therefore-called Heckscher-Ohlin theory of international trade.
  • Since there is wide agreement among modern economists about the explanation of international trade offered by Heckscher and Ohlin this theory is also called modern theory of international trade. Further, since this theory is based on general equilibrium analysis of price determination, this is also known as General Equilibrium Theory of International Trade.
  • In simple terms, Heckscher-Ohlin theory states that, it is the resources endowments that describe the basis of trade i.e., A labour rich country will produce and export labour intensive commodities and capital rich country will produce and export capital intensive commodity.

Assumptions

  1. Two countries, two commodities and two factors.
  2. Each commodity is produced under constant returns to scale.
  3. Perfect competition in all markets.
  4. Technology is given and identical.
  5.  Consumer tastes are identical across countries.
  6.  Factors are mobile within each country but immobile between countries.
  7. No transportation costs.
  8. Free Trade.
  9. Commodities are ranked in terms of their factor intensity.

Let us assume that the two commodities are- commodity X (capital commodity) and commodity Y (agriculture commodity). Take Commodity X be capital-intensive, that is, they can be produced with less labour relative to capital and it has a higher capital-labour ratio and Commodity Y be labour-intensive commodity that is, it requires a substantial amount of labour relative to capital. Further assume that Nation 1 specializes in producing the capital commodity and Nation 2 is considered to be an agricultural country and thus specializes in commodity 2

Factor Intensity

  • The term “factor intensity” refers to the relative proportion of the various factors of production used to make a given product. In other words, factor intensity looks at how much an industry uses capital, for instance, as opposed to labour.
  • So when we say that commodity Y is labour-intensive, it means that labour is used relatively more in the production of commodity Y than in the production of Commodity X.
  • This is equivalent to saying that labour-capital ratio (L/K) used in production of commodity Y is greater than L/K used in production of Commodity X i.e. (L/K) commodity Y > (L/K) commodity X , or, (K/L) Commodity X > (K/L) commodity Y when defined in terms of capital-labour ratio. Similarly for capital-intensive commodity commodity X, (K/L) commodity X> (K/L) commodity Y or (L/K) commodity X < (L/K) commodity Y.
  • Since (K/L) commodity X> (K/L) commodity Y, this implies commodity X is capital-intensive and commodity Y is labour-intensive. Note: while talking about factor intensity, we always talk in terms of capital per unit of labour and not in absolute terms.
  • Even though in above example absolute amount of capital used is also higher in production of commodity Y than commodity X but the factor intensity should always be looked in relative terms.
  • Plotting capital and labour values on a diagram shows us that steeper the line, greater the slope and hence the product with steeper slope is more capital-intensive.

Factor Abundance

  • Factor abundance is the resource richness of nations. There are two definitions of factor abundance: one in terms of physical quantities and other in terms of factor prices.
  • According to the definition in terms of physical units, the factor abundance of one nation is defined by the relative endowment of capital to labour in one nation relative to another nation. Nation1 is capital abundant if the ratio of the total amount of capital to the total amount of labour (TK/TL) available in Nation 1 is greater than that in Nation 2 i.e. (TK/TL) NATION 1> (TK/TL)NATION 2.
  • We will assume that Nation 1 is capital-abundant nation and Nation 2 is labour-abundant.
  • According to the definition in terms of factor prices, Nation 1 is capital abundant if the ratio of the rental price of capital to the price of labour time (PK/PL) is lower in Nation 1 than in Nation 2. Since rental price of capital is usually taken to be the interest rate (r) while the price of labour time is the wage rate (w), PK/PL = r/w. Then (PK/PL)) NATION 1 < (PK/PL) NATION 2 or (r/w) )NATION 1 < (r/w)NATION 2. This is because capital abundance in Nation 1 leads to a lower price of it in the said nation and similarly higher price of the relatively scarce factor.
  • We all know that demand and supply together determines the price of a commodity. But here we assume that demand conditions are same everywhere, and it is only the supply of various factors of production that differ. Hence it becomes the sole determinant of as studied above, nation 1 is the capital abundant nation and each factor is paid according to their marginal product so the price of capital will be lower in Nation 1 relative to Nation 2 where labour will be cheaply available as it is a labour abundant country.
  • So now capital is cheap and labour is expensive in Nation 1 and labour is cheap and capital is expensive in Nation 2. Stated in equation terms, this means (r/w) )NATION 1 < (r/w)NATION 2 or (w/r) )NATION 1 >(w/r)NATION 2.

Note: we take factor abundance in factor prices because this definition considers both demand and supply factors (price of any commodity is determined by demand and supply) while physical quantity definition takes only supply factors. However, since we have assumed tastes to be same in both nations, so the two definitions coincide.

So we have-

  • Nation 1 as the capital abundant nation and commodity X is the capital-intensive commodity, Nation 1 can produce relatively more of commodity X and at a lower cost than Nation 2.
  • Nation 2 is the Labour abundant nation and commodity Y is the labour intensive commodity, Nation 2 can produce relatively more of commodity Y and at a lower cost than Nation 1.
  • This gives us the production frontier (PPF) for the two nations.

Nation 2 PPF is skewed towards output of commodity Y and Nation 1 PPF is skewed towards commodity X . It can be seen from the diagram that PPF of Nation 2 is relatively flatter and wider than Nation 1.

The different shapes of different production possibility frontiers are due to the fact that the two countries have different amount of the two factors of production. The PPF is biased towards the factor in which they have abundance.

The Heckscher-Ohlin Theorem

  • The theorem states that a nation should produce and export the commodity whose production requires the intensive use of the nation’s relatively abundant (and cheap) factor and import the commodity whose production requires the intensive use of the nation’s relatively scarce (and expensive) factor. In simple words, capital-intensive country exports capital intensive product and labour intensive country exports labour-intensive product.
  • It is only the difference in physical availability of resources or supply of factors of production that causes the difference in relative commodity prices in different nations and hence creates a basis for trade.
  • The H-O theorem examines resource differences as the only source of trade. It shows the proportions in which different factors of production are available in different countries and the proportions in which different they are used in producing different commodities, it is also referred to as factor-proportions or factor-endowment theory.
  • To be noted that the assumptions of equal tastes and same technology need not be exactly equal, the results will follow even if they are broadly similar and H-O model qualifies to be a general equilibrium model.
  • In the above diagram, as shown earlier, the PPF for Nation 2 is skewed towards commodity Y- the labour-intensive commodity and PPF for Nation 1 is skewed towards commodity X, the capital-intensive commodity. Since tastes are assumed to be the same in both nations, the preferences of consumers can be represented by a single IC.
  • The same IC I is tangent to both nations’ PPF at point A and A’ respectively. This is the autarky (no-trade) equilibrium where the production and consumption points are same for both nations. The price line for both nations is given by PA for Nation 1 and PA’ for Nation 2.(We can show different ICs for the two nations but since tastes are identical, it can be represented by a single IC. This is done to keep the process simple and easy to understand.)
  • From the above diagram it can be clearly seen that slope of PA’ < PA. This means Nation 1 has a lower price for commodity X and thus holds comparative advantage in producing commodity X and Nation 2 has a comparative advantage in commodity Y.
  • The figure below shows how the two countries reach equilibrium when they trade.
  • Nation 2 will specialize in production of commodity Y and will reach point B’. Similarly, Nation 1 will specialize in production of commodity X and will reach point B where the PPF of the two nations are tangent to their relative price line i.e. the rate at which they exchange with each other.
  • Nation 2 will export commodity Y and Nation 1 will export commodity X and in this process they both will reach equilibrium point E on IC. Here we can see that, Nation 2 exports of commodity Y equals Nation 1 imports of commodity Y and Nation 1 exports of commodity 1 equals Nation 2 imports of commodity X.
  • The two trade triangles BCE and B’C’E are equal. At point E, Nation 2 has more of commodity X but less of commodity Y than before it had at previous point but it still gains because point E is on a higher IC. Similarly, at point E Nation 1 involves more of commodity Y and less of commodity X but it is also better off by trading because it is on a higher IC.
  • So both nations gain from trade by consuming on a higher Indifference Curve. Hence following the H-O theorem, the two nations gain from trade.

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