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Heckscher-Ohlin Theory April 2, 2010

Posted by Chetan Chitre in International Business Management, International Trade Theory.
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Introduction –

Heckscher-Ohlin Theory is also called the Modern Theory of International Trade. This theory was given by Bertin Ohlin and Eli Heckscher around 1930s.

While the H-O Theory recognized the fact that International Trade will take place primarily because of differences in prices of goods in two countries which in turn will arise on account of difference in costs.

However, while the Classical theories stopped at this point, the H-O theory went a step ahead and enquired into the reasons for the differences in cost of production between two countries. In other words it enquired into the question – why does a particular country enjoy a cost advantage?

Another major difference between the Classical Theory and the H-O Theory was the fact that while the classical theory was based on labor theory of value and therefore considered labor as the sole factor of production. However, the H-O theory widened the scope to include more than one factor of production.

In fact, the H-O Theory stated that the basic reason for the difference in costs was the differences in factor endowments between two countries.

H-O Theory –

H-O Theory states that the differences in costs of production between two countries would arise primarily on account of the differences in the factor endowments. The theory can be explained as follows –

Assumptions –

# We assume a two countries (Country A and B) – two commodities (Bread and Cloth) situation as in the classical theories

# However, now we further assume that each country is endowed with 2 factors of production i.e. Labor and Kapital. The proportion of labor and kapital in each country is different. This would mean that the relative prices of labor and kapital in the two countries will also be different.

# We also assume that for producing each of the two commodities requires different proportions of labor and kapital. i.e. different production functions for different commodities.

# Production function displays constant returns to scale for both commodities.

# Factors of production cannot be moved across countries.

# While there are 2 factors of production, each of the factors is homogenous i.e. 1 unit of labor is similar to the other and so also for kapital.

# All factors of production are fully employed and there is perfect competition in both countries

# No currency.

# No restriction of Foreign trade.

# No change in technology. Further technology is same in both countries.

Explanation –

Given the above assumptions the H-O Theory can be explained using the following diagram –

# Suppose a situation as given in diagram -1

# X- axis measures units of Labor while Y- axis measures units of kapital.

# DD1 is the isoquant curve representing different combinations of kapital and labor required to produce 10 units of Bread. CC1 is the isoquant curve for production of 10 units of Cloth. Clearly as BB1 is closer to Y- axis indicates that production function for bread is more kapital intensive while that of cloth is labor intensive.

# Let AA1 be a resource constraint for country A. Given the resources the producer country can employ a maximum of OA units of kapital or OA1 units of labor. The slope of the resource constraint line is determined by the relative prices of labor and kapital.

# With the given isoquants and the resource constraint, the country is in a position to produce Bread at point Q and Cloth at point P as these are the points at which both the isoquants are tangential to the resource constraint.

# Now assume a situation as in diagram -2 where there is a change in the relative prices of labor and kapital. Say a country B which has abundant labor. The slope of the resource constraint changes to BB1.

# It can be seen that with the resource constraint slope at BB1, the country can produce 10 units of Bread on DD1. However, it can produce a higher amount of cloth at CC2 with same amount of resources.

# On the other hand, it can produce the original quantity of cloth CC1 with much lesser resources BB1.

# It is clear thus that as country B is abundant in labor, it is more efficient in production of cloth, which is a labor intensive commodity. Country B would thus specialize in production of cloth and export cloth to country A.

# Whereas, country A, being a capital abundant country, would be more efficient in production of Bread and end up exporting bread to country B.

Comparison of H-O Theory and the Classical Theories –

(a) Considers 2 factors instead of the single factor model of the classical theories

(b) Regards differences in factor endowments as the basis for determining pattern of international trade, whereas Ricardian theory does not take note of this.

(c) Considers relative prices of factors as the basis for determining relative prices of goods, while Ricardian Theory considers only relative prices of factors.

(d) Classical Theories concentrate of gains from trade while the H-O Theory concentrates of the basis for trade.

(e) Recognizes the possibility of differences in productions function of different commodities.

Most Criticisms of the Theory would as usual be derived from its assumptions

Other Criticism –

Leontiff Paradox – Leontiff surveyed the US economy in the 1950s and found that the US despite being a Kapital surplus and labor scarce country has been exporting more of labor intensive products. This was an apparent contradiction to the H-O Theory and thus raised a number of doubts on the validity of the theory.

As a result of this a number of other theories have come up in the recent past. The prominent among them is the –

Life Cycle Theory –

According to this theory –

# Stage -1 – The Developed countries invest a lot of fund in Research and Development activities. As a results new innovations in products often take place in developed countries. Thus products that use latest technology often are manufactured and exported by the developed countries.

# Stage -2 – As production becomes streamlined and the innovativeness of the product diminishes. In this stage the focus is on reducing costs. Further, as a result of lower costs, the key market for the product also shifts to the emerging economies. The production gets shifted to emerging markets. Emerging economies then become key exporters of this product.

# Stage -3 – In this stage the product becomes obsolete and the production and consumption is limited to the poor Less Developed Countries.

Other Factors Influencing International Trade –

# Attitude and policies of government towards foreign trade

# Visionary political leadership

# Local entrepreneurship and its willingness to face global competition

# Skill, expertise and work culture among the people

# Natural resource endowments

# Geographical location

# Emergence of Corporates with global ambitions

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