Heckscher-Ohlin theory

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It builds on David Ricardo's theory of comparative advantage by predicting patterns of commerce and production based on the factor endowments of a trading region.

The model essentially says that countries export products that use their abundant and cheap factors of production, and import products that use the countries' scarce factors. Relative endowments of the factors of production landlaborand capital determine a country's comparative advantage.

Countries have comparative advantages in those goods for which the required factors of production are relatively abundant locally. This is because the profitability of goods is determined by input costs. Goods that require inputs that are locally abundant are cheaper to produce than those goods that require inputs that are locally scarce.

For example, a country where capital and land are abundant but labor is scarce as a comparative advantage in goods that require lots of capital and land, but little labor—grains. If capital and land are abundant, their prices are low.

As they are the main factors in the production of grain, the price of grain is also low—and thus attractive for both local consumption and export. Labor-intensive goods on the other hand is very expensive to produce since labor is scarce and its price is high. Therefore, the country is better off importing those goods.

The Ricardian model of comparative advantage has trade ultimately motivated by differences in labour productivity using different "technologies". Heckscher and Ohlin did not require production technology to vary between countries, so in the interests of simplicity the "H—O model has identical production technology everywhere".

Ricardo considered a single factor of production labour and would not have been able to produce comparative advantage without technological differences between countries all nations would become autarkic at various stages of growth, with no reason to trade with each other. The H—O model removed technology variations but introduced variable capital endowments, recreating endogenously the inter-country variation of labour productivity that Ricardo had imposed exogenously.

With international variations in the capital endowment like infrastructure and goods requiring different factor "proportions", Ricardo's comparative advantage emerges as a profit-maximizing solution of capitalist's choices from within the model's equations.

The decision that capital owners are faced with is between investments in differing production technologies; the H—O model assumes capital is privately held.

Bertil Ohlin first explained the theory in a book published in Ohlin wrote the book alone, but he credited Heckscher as co-developer of the model because of his earlier work on the problem, and because many of the ideas in the final model came from Ohlin's doctoral thesis, supervised by Heckscher. Interregional and International Trade itself was verbose, rather than being pared down to the mathematical, and appealed because of its new insights.

The original H—O model assumed that the only difference between countries was the relative abundances of labour and capital. The original Heckscher—Ohlin model contained two countries, and had two commodities that could be produced. The model has "variable factor proportions" between countries—highly developed countries have a comparatively high capital-to-labor ratio compared to developing countries.

This makes the developed country capital-abundant relative to the developing country, and the developing nation labor-abundant in relation to the developed country. With this single difference, Ohlin was able to discuss the new mechanism of comparative advantageusing just two goods and two technologies to produce them. One technology would be a capital-intensive industry, the other a labor-intensive business—see "assumptions" below.

The model has been extended since the s by many economists. These developments did not change the fundamental role of variable factor proportions in driving international trade, but added to the model various real-world considerations such as tariffs in the hopes of increasing the model's predictive power, or as a mathematical way of discussing macroeconomic policy options. Notable contributions came from Paul SamuelsonRonald Jonesand Jaroslav Vanekso that variations of the model are sometimes called the Heckscher-Ohlin-Samuelson model or the Heckscher-Ohlin-Vanek model in the neo-classical economics.

Some of these have been relaxed for the sake of development. These assumptions and developments are listed here. This assumption means that producing the same output of either commodity could be done with the same level of capital and labour in either country. Actually, it would be inefficient to use the same balance in either country because of the relative availability of either input factor but, in principle this would be possible. Another way of saying this is that the per-capita productivity is the same in both countries in the same technology with identical amounts of capital.

Countries have natural advantages in the production of various commodities in relation to one another, so this is an "unrealistic" simplification designed to highlight the effect of variable factors. This meant that the original H—O model produced an alternative explanation for free trade to Ricardo's, rather than a complementary one; in reality, both effects may occur due to differences in technology and factor abundances. In addition to natural advantages in the production of one sort of output over another wine vs.

Ohlin said that the H—O model was a long-run model, and that the conditions of industrial production are "everywhere the same" in the long run. In a simple model, both countries produce two commodities. Each commodity in turn is made using two factors of production.

The production of each commodity requires input from both factors of production—capital K and labor L. The technologies of each commodity is assumed to exhibit constant returns to scale CRS. CRS technologies implies that when inputs of both capital and labor is multiplied by a factor of kthe output also multiplies by a factor of k.

For example, if both capital and labor inputs are doubled, output of the commodities is doubled. In other terms the production function of both commodities is " homogeneous of degree 1".

The assumption of constant returns to scale CRS is useful because it exhibits a diminishing returns in a factor. Under constant returns to scale, doubling both capital and labor leads to a doubling of the output. Since outputs are increasing in both factors of production, doubling capital while holding labor constant leads to less than doubling of an output.

Diminishing returns to capital and diminishing returns to labor are crucial to the Stolper—Samuelson theorem. The CRS production functions must differ to make trade worthwhile in this model. For instance if the functions are Cobb—Douglas technologies the parameters applied to the inputs must vary. An example would be:. Where A is the output in arable production, F is the output in fish production, and KL are capital and labor in both cases.

In this example, the marginal return to an extra unit of capital is higher in the fishing industryassuming units of fish F and arable output A have equal value.

The more capital-abundant country may gain by developing its fishing fleet at the expense of its arable farms. Conversely, the workers available in the relatively labor-abundant country can be employed relatively more efficiently in arable farming. Within countries, capital and labor can be reinvested and reemployed to produce different outputs. Similar to Ricardo's comparative advantage argument, this is assumed to happen without cost.

If the two production technologies are the arable industry and the fishing industry it is assumed that farmers can shift to work as fishermen with no cost and vice versa. It is further assumed that capital can shift easily into either technology, so that the industrial mix can change without adjustment costs between the two types of production.

For instance, if the two industries are farming and fishing it is assumed that farms can be sold to pay for the construction of fishing boats with no transaction costs. The basic Heckscher—Ohlin model depends upon the relative availability of capital and labor differing internationally, but if capital can be freely invested anywhere, competition for investment makes relative abundances identical throughout the world.

Essentially, free trade in capital provides a single worldwide investment pool. A large country would receive twice as much investment as a small one, for instance, maximizing capitalist's return on investment. As capital controls are reduced, the modern world has begun to look a lot less like the world modelled by Heckscher and Ohlin.

It has been argued that capital mobility undermines the case for free trade itself, see: Capital mobility and comparative advantage Free trade critique. Like capital, labor movements are not permitted in the Heckscher—Ohlin world, since this would drive an equalization of relative abundances of the two production factors, just as in the case of capital immobility.

This condition is more defensible as a description of the modern world than the assumption that capital is confined to a single country. The 2x2x2 model originally placed no barriers to trade, had no tariffsand no exchange controls capital was immobile, but repatriation of foreign sales was costless.

It was also free of transportation costs between the countries, or any other savings that would favor procuring a local supply. If the two countries have separate currenciesthis does not affect the model in any way— purchasing power parity applies. Since there are no transaction costs or currency issues the law of one price applies to both commodities, and consumers in either country pay exactly the same price for either good.

In Ohlin's day this assumption was a fairly neutral simplification, but economic changes and econometric research since the s have shown that the local prices of goods tend to correlate with incomes when both are converted at money prices though this is less true with traded commodities.

Neither labor nor capital has the power to affect prices or factor rates by constraining supply; a state of perfect competition exists. The results of this work has been the formulation of certain named conclusions arising from the assumptions inherent in the model. Exports of a capital-abundant country come from capital-intensive industries, and labour-abundant countries import such goods, exporting labour-intensive goods in return. Competitive pressures within the H—O model produce this prediction fairly straightforwardly.

Conveniently, this is an easily testable hypothesis. When the amount of one factor of production increases, the production of the good that uses that particular production factor intensively increases relative to the increase in the factor of production, as the H—O model assumes perfect competition where price is equal to the costs of factors of production.

This theorem is useful in explaining the effects of immigration, emigration, and foreign capital investment. However, Rybczynski suggests that a fixed quantity of the two factors of production are required. This could be expanded to consider factor substitution, in which case the increase in production is more than proportional. Relative changes in output goods prices drive the relative prices of the factors used to produce them.

If the world price of capital-intensive goods increases, it increases the relative rental rate and decreases the relative wage rate the return on capital as against the return to labor.

Also, if the price of labor-intensive goods increases, it increases the relative wage rate and decreases the relative rental rate. Free and competitive trade makes factor prices converge along with traded goods prices. The FPE theorem is the most significant conclusion of the H—O model, but also has found the least agreement with the economic evidence.

Neither the rental return to capital, nor the wage rates seem to consistently converge between trading partners at different levels of development. The Stolper—Samuelson theorem concerns nominal rents and wages. The Magnification effect on prices considers the effect of output-goods price-changes on the real return to capital and labor.

This is done by dividing the nominal rates with a price indexbut took thirty years to develop completely because of the theoretical complexity involved. Heckscher and Ohlin considered the Factor-Price Equalization theorem an econometric success because the large volume of international trade in the late 19th and early 20th centuries coincided with the convergence of commodity and factor prices worldwide. Modern econometric estimates have shown the model to perform poorly, however, and adjustments have been suggested, most importantly the assumption that technology is not the same everywhere.

This change would mean abandoning the pure H—O model. In an econometric test by Wassily W. Leontief of the H—O model found that the United States, despite having a relative abundance of capital, tended to export labor-intensive goods and import capital-intensive goods. This problem became known as the Leontief paradox.

Alternative trade models and various explanations for the paradox have emerged as a result of the paradox.

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