Heckscher - Ohlin Theory of International Trade

Put forth by two Swedish Economists

Eli Hecksher

Bertil Ohlin

 This theory is also known as Factor Proportions Factor Intensity Theory The core of the H-O Theory is that international trade takes place because commodity prices are different in different countries Commodity prices are different because factor prices are different in different countries Factor prices are different because the distribution of the factor resources is different in different countries

Assumptions
(1) It considers two countries, two commodities and two factors of production (2) Factors of production are perfectly mobile within a country and immobile between the countries (3) There is perfect competition in the commodity as well as the factor markets

(4) Factor endowments are different in different countries

(5) Factor intensities are different for the production of different goods

(6) There is free and unrestricted trade between two countries

(7) Demand functions for different goods are identical in both the countries (8) Techniques of production are constant

(9) There is the absence of transport costs. Product prices are influenced exclusively by factor prices (10) International trade leads to factor - price equalization

(a) Factor Endowments: According to the H-O Theory, the factor endowments are distributed differently in different countries; Countries like Argentina and Australia have more of land and hence concentrate on the production of those commodities which require more land for their production. India has plenty of labour supply and hence specializes in the production of Labour-intensive goods. United States has abundant supply of capital and hence concentrates on the production of capital-intensive goods. Differences in factor endowments lead to differences in factor prices.

(b) Factor Intensities According to this theory, the factor intensities are different for the production of different commodities. In other words, the proportions of the factors of production are different for the production of different goods. For. Example, wheat requires more land while machine tools require more capital for their production. Now, Argentina produces more wheat because wheat requires more land which Argentina has in plenty. United States produces more machine tools because machine tools require more capital which United States has in plenty. Thus, according to the H-O Theory, each country specializes in the production of that commodity for the production of which it requires more of that factor of production which the country has in abundance.

Superiority of the H-O Theory The H-O Theory represents a significant improvement upon the Ricardian theory. The followinq are the points of the superiority of the H-O theory: (1) The H-O Theory is based on the general theory of value, while the Ricardian theory is based on the labour theory of value. (2) While Ricardo considered only one factor of production, H-O Theory considers more than one factor of production. (3) Further, while Ricardo made a division between internal trade and international trade, the H-O Theory makes no such division. In fact, according to the H-O Theory, international trade is but a special case of inter - local or inter - regional trade. (4) While the Classical theory is normative in nature, the H-O Theory makes contribution mainly to positive economics. (5) The H-O Theory points out that the cause for comparative cost differences is the differences in factor endowments and prices, a point overlooked by Ricardo. (6) The H-O Theory is superior because it attaches importance to differences in the production functions of the commodities. (7) The H-O Theory brings about a successful integration between theories of value and trade, which Ricardian theory failed to do. Thus, the H-O Theory registers an improvement upon the classical comparative costs theory of international trade.

Criticism Despite its superiority, the H-O Theory is criticized on the followinq grounds: (1) Leontief Paradox This paradox is associated with the name of W.W.Leontief, an American economist, who conducted an empirical study of the American foreign trade to test the validity of the H-O Theory. In his study, Leontief found that American exports had more labour content disproving the basic proposition of the H-O Theory. Similar studies conducted in Japan and Canada also disproved the validity of the H-O Theory. (2) Unrealistic Assumptions Like the Ricardian theory, the H-O Theory also is based upon unrealistic assumptions like free trade, perfect competition, zero transport costs etc. (3) Trade between Countries with Identical Factor Endowments According to critics, trade takes place even between countries with identical factor endowments - for example, between India and China. (4) Partial Equilibrium Analysis The H-O Theory remains, by and large, a part of the partial equilibrium analysis. It has failed to develop a general equilibrium concept.

(5) Static Analysis The H-O Theory is criticized as a static analysis because it assumes fixed quantities of the factors of production, given production functions, incomes and costs. (6) Neglects Product Differentiation The H-O Theory overlooks the role played by product differentiation in international trade. (7) Commodity Prices determine factor prices According to Wijanholds, a South African economist, it is the commodity prices which determine factor prices and not the other way. (8) Overlooks Factor Demand The H-O Theory has overlooked the influence of demand for factors on their prices. (9) Neglect of Technological change Heckscher and Ohlin as sumo identical production function for a commodity and hence overlook technological changes. (10) No Complete Factor - price Equalisation The Factor - price Equalisation Theorem has been criticized. At best, there can only be a tendency towards equalization of factor prices. In spite of the above limitations, the H-O Theory is important because of its objectivity and simplicity. This theory has been considered to be a simple model of international trade. Undoubtedly, the H-O model occupies the very centre of international trade theory.