Modern theory of international trade: the Heckscher-Ohlin theory

1. Background

The classical theory explained trade by differences in comparative labour costs but did not explain why those costs differ. The Swedish economist Eli Heckscher (article of 1919) and his student Bertil Ohlin (Interregional and International Trade, 1933) answered that question. Ohlin shared the Nobel Prize in Economics in 1977 partly for this work. Their theory is also called the factor endowment or factor proportions theory.

2. Statement

Countries differ in their endowments of factors of production (labour, capital, land), and goods differ in the proportions of factors they need. Hence:

A country exports goods that use its abundant factor intensively, and imports goods that use its scarce factor intensively.

A capital-abundant country (the United States) exports capital-intensive goods (machinery); a labour-abundant country (India) exports labour-intensive goods (textiles, garments, leather goods). Ohlin: “The immediate cause of international trade is always that goods can be bought cheaper from abroad than they can be produced at home,” and the cheapness comes from differences in factor supplies.

3. Assumptions

1. Two countries, two goods, two factors (2 × 2 × 2 model).
2. Countries differ in factor endowments.
3. Identical production functions (same technology) in both countries.
4. Goods differ in factor intensity: one is capital-intensive, the other labour-intensive, at all factor prices (no factor intensity reversal).
5. Constant returns to scale.
6. Perfect competition in goods and factor markets; full employment.
7. Factors mobile within a country, immobile between countries.
8. Free trade, no transport costs.
9. Identical tastes and demand patterns in both countries.

4. Two definitions of factor abundance

• Price criterion (Ohlin): a country is capital-abundant if the price of capital relative to labour (r/w) is lower there than in the other country.
• Physical criterion: a country is capital-abundant if its ratio of total capital to total labour (K/L) is higher than in the other country.

The two give the same answer if demand conditions are the same; the price criterion includes the effect of demand, the physical one only supply.

5. Illustration

Let country A (America) have K/L = 4 and country B (India) K/L = 1. Steel needs much capital per worker; cloth needs much labour per unit of capital. Because capital is relatively plentiful in A, interest is low relative to wages there; in B wages are low relative to interest. Therefore:

The chain of reasoning is: different factor endowments lead to different relative factor prices, which lead to different relative commodity prices, which are the basis of trade. On a diagram, A’s production possibility curve is skewed towards steel and B’s towards cloth; with identical tastes, each country’s pre-trade price ratio favours the good using its abundant factor.

6. Factor price equalisation theorem

A corollary developed by Ohlin and proved rigorously by Paul Samuelson (1948, 1949) is the Heckscher-Ohlin-Samuelson theorem: free trade tends to equalise factor prices between countries. As B exports cloth, demand for its abundant labour rises and wages rise; as it imports steel, demand for its scarce capital falls and interest falls. The reverse happens in A. Trade in goods is thus a substitute for the movement of factors. Ohlin himself held that equalisation would be only partial because of transport costs, tariffs and imperfect competition; Samuelson showed full equalisation under the strict assumptions.

7. The Leontief paradox

Wassily Leontief (1953), using input-output tables for the United States in 1947, found that American import-competing goods were more capital-intensive than its exports. The most capital-abundant country in the world appeared to export labour-intensive goods, contrary to the theory. Explanations offered: American labour is far more productive (so in effective units the US is labour-abundant, as Leontief himself suggested); the theory ignores natural resources; tariffs protected labour-intensive US industries; American tastes are biased towards capital-intensive goods; and factor intensity reversal may occur.

8. Criticisms

1. Unrealistic assumptions: technology differs between countries; perfect competition and full employment are rare.
2. Factor intensity reversal: a good may be labour-intensive in one country and capital-intensive in another (rice in India and the US).
3. Factors are not homogeneous: labour and capital differ in quality.
4. Demand is ignored by the physical criterion; strong home demand for a good can reverse the pattern.
5. Static: ignores technical progress, economies of scale and product cycles; newer theories (Linder’s demand similarity, Posner’s technological gap, Vernon’s product life cycle, Krugman’s intra-industry trade) explain much of modern trade between similar countries.
6. Empirical failure: the Leontief paradox.
7. Factor prices have not equalised in practice: wages in India and the US remain far apart.

9. Classical and modern theory compared

The modern theory does not overthrow the classical one; it supplements it by explaining the source of comparative advantage.

How this is examined

For “critically explain”, spend about half the answer on statement, assumptions and illustration, then factor price equalisation and the Leontief paradox, and end with criticisms. For a six-mark note, the statement, the illustration table and three criticisms will do. The comparison table answers “distinguish the classical and modern theories”.