The Development and Testing of Heckscher-Ohlin Trade Models - Literature review Example

International Trade of the Contents Reason for Trade 3 Hecksher-Ohlin Model 7 Fitting of the H-O Model 8 References 10 Reason for Trade Early in the pre-historic era, before the system of trade was introduced, people in the villages used to store their excess produced crops and grains (Lundvall, et al., (2011). As time passed, they discovered that storage of foods was not a viable option because crops were getting spoiled. It meant loss of effort and resources. So, they thought of selling the crops to other villages in return for those food crops that they could not produce. In this way, villages started trading among themselves. They procured those commodities and crops which had excess demand than the supply in their village. The transfer of possession of commodities and services from one individual or unit to another in exchange for other goods and services or for money is therefore known as trade. It is also known as a financial transaction (Hahnel, 2015). The previous form of trade was called the ‘barter system’ in which goods and services were exchanged for other commodities and services. No medium like money was there for exchange. However, it had some limitation like existence of double coincidence of wants, indivisibility of certain commodities, lack of standards for deferred payments, etc. (Baldwin, 2008) Krugman, P. R. (2008) explained that trade occurs between nations due to the difference in autarky price ratio of tradable between nations. Suppose that, there are two nations A & B and two tradable X and Y. Now, if it is found that (PX/PY) of nation A is less than (PX/PY) of nation B, then commodity X is relatively cheaper and commodity Y is relatively costlier in country A compared to country B in autarky. So, if trade opens up, then trade flow will be country A trading X to B and B trading Y to A. The difference in autarky price ratio can occur either from demand side or from supply side. If the supply conditions in the two nations are similar but the residents of nation B has a strong demand bias in favor of commodity X, then there may arise excess demand for X in autarky in B, for which the relative price of X will be relatively higher in B compared to A. On the other hand, if the demand conditions of two nations are identical, then the difference may arise from the supply side. It may so happen that nation A users superior production technology to produce X compared to B or it may be the fact that nation A is labor abundant and commodity X is labor intensive, for which the factor cost for X will be lower in A compared to B. All the above explanation show how inter-industry trade occurs between nations. In 1980s, Professor Krugman advocated the new trade theory in which he has explained that intra-industry trade can take place between countries due to variety seeking attitude of the consumers, product differentiation and Increasing Returns to Scale (IRS). There are two kinds of gains from trade: Static Gains and Dynamic Gains. When factors of production are reallocated in sectors where the nation has a comparative advantage, then it is known as Static Gains. The gains which get accumulated over a period of time are called Dynamic Gains (Folsom, et al, 2012). Gains from trade can be distributed into gain from exchange and gains from specialization (Krugman, (2008). The introduction of trade entails increased consumption level and production level for both the consumers and producers. The following figure depicts this decomposition. (Source: Krugman, 2008) Where, AB= Transformation curve (Production Possibility Curve) symbolizing supply side and the concave AB curve here shows that there exists increasing opportunity cost in production. CI0= Community Indifference Curve symbolizing demand side, E= autarky equilibrium where AB just touches CI0 and PP= domestic price ratio. Community Indifference curve shows different combinations of the consumption of the two commodities (X and Y) such that the community as a whole gets the same level of satisfaction. Transformation curve shows the maximum amount of production of one commodity for each possible units of production of the other when: Resources are given and they have alternative uses, Production technology is given, Resources are fully employed. Figure: Gains from Trade (Source: Krugman, 2008) Since there has been an increase in the price of X in international market, producers decrease the production of Y and increase that of X. This results in the movement from point E to N along the transformation curve where International price line P2 is tangent to AB at N. The gains from trade are maximized at N and C’ as at P2, Marginal Rate of Transformation (MRT) in production equals Marginal Rate of Substitution (MRS) in consumption (Clarke & Kulkarni, (2009). The movement from CT0 to CI2 shows that there is improvement in welfare. Nyasha & Odhiambo, (2015) suggested that gains from trade occur due to production specialization from economies of scale, division of labor, economies of scope, etc., incrimination in total output possibilities, expansion of the size of the market, gains from rising competition, increase in national income and welfare of countries, increase in savings and investment, efficient allocation and utilization of resources, etc. Hecksher-Ohlin Model According to Baldwin (2008), Hecksher-Ohlin (H-O) model takes into account two factors of production (Labor & Capital) in its study. It is constructed on David Ricardo’s theory of Comparative Advantage. According to the law of Comparative Advantage, there is still a basis for mutually beneficial trade even if one nation is less efficient than the other in production of both the commodities. The nation should specialize in which they have comparative advantage (that is, lower labor hour required to produce one unit of output) and import the products which have comparative disadvantage. According to H-O model, trade between nations results from the fact that different nations have different factor endowments (Schulze & Ursprung, 2002). H-O model examines the effect of trade on income-distribution between factors of a nation. Baldwin, (2008) pointed out the assumptions of the model, which are mentioned below: It is a 2×2×2 model. There are 2 nations A &B, both produce 2 commodities X & Y through the use of 2 factors of productions Labor (L) & Capital (K), Each nation has given endowment of L & K and they are fully employed. Production functions differ between commodities but are the same in both nations. However, suppose commodity X is relatively capital-intensive compared to Y in both the nations at the same relative factor prices, that is, (K/L)│X > (K/L)│Y. If this relation is true for all possible relative factor prices, then it can be said that there exist no factor intensity reversals (Baldwin, 2008). Presence perfect competition in both product and factor markets, Both the goods are manufactured under Constant Returns to Scale in both the nations, Commodities are freely mobile across nations but there is no International mobility of factors, Trade is free and costless (Clarke & Kulkarni, (2009). H-O model explains that a nation exports that good in which its abundant factor is used more intensively. It states that the capital abundant country exports capital intensive goods and labor abundant nation exports labor intensive goods (Williamson, 2006). Fitting of the H-O Model Two countries are taken here for the examination of the fitness of the H-O model. Singapore and Malaysia have contrastingfeatures. Clarke and Kulkarni, (2009) argued that while Singapore is known to be a capital abundant nation and world financial hub, Malaysia is a labor abundant nation and has capital scarcity. It has been found that they are identical in terms of their economy, politics and geography making them worthwhile countries to compare when testing the model. The data for relative factor intensities of two sectors, manufacturing and agriculture/mining were collected and they suggest that Singapore’s exports are capital intensive in nature and Malaysia’s exports are relatively labor intensive. Hence, this satisfies the H-O theorem (Schulze & Ursprung, 2002). However, when comparisons were made between the factor abundance ratio and factor intensity ratio of the two sectors, it was found that Singapore’s exports had relatively lower capital intensity than expected in the model. The K/L ratio was found to be 297 compared to Malaysia’s 59. This implies that Singapore is approximately 5 times more capital abundant. Other estimation implied that 68% of Singaporean goods exports were labor intensive and that of Malaysian commodity exports was 90% labor intensive. All these results prove that H-O theorem fits perfectly for this example (Held, 2013). Nyasha, S. and Odhiambo, N. M. (2015) emphasizes on growth related to trade. They explained how trade promotes growth in the nations. This helped in analyzing the concept of “Gains from Trade”. However, there were not many data oriented analysis. So it lacked empirical studies. The article by Clarke, A. and Kulkarni, K.G. (2009) has been very effective in providing the important data related to the fitting of the H-O model. The article elaborately explained and compared the different ratios. It also applied statistical tools for enhanced hypothesis testing procedures. References Baldwin, R. E. (2008). The Development and testing of Heckscher-Ohlin trade models: a Review. Massachusetts: MIT Press Books. Clarke, A. & Kulkarni, K.G. (2009). Testing of the Application of Heckscher-Ohlin Theorem to Contemporary Trade between Malaysia and Singapore. Retrieved from Folsom, R. H., Gordon, M. W., Spanogle Jr, J. H., Fitzgerald, P. L. & Van Alstine, M. P. (2012). International Business Transactions: Trade and Economic Relations (Special Break-out edition). Minnesota: West. Hahnel, R. (2015). The ABCs of Political Economy. Chicago: University of Chicago Press. Held, D. (2013). Global Covenant: The Social Democratic Alternative to the Washington Consensus. New Jersey: John Wiley & Sons. Krugman, P. R. (2008). International Economics: Theory and policy, 8/E. New Delhi: Pearson Education India. Lundvall, B. Å., Joseph, K. J., Chaminade, C., & Vang, J., (2011).Handbook of Innovation Systems and Developing Countries: Building Domestic Capabilities in a Global Setting. Cheltenham: Edward Elgar Publishing. Nyasha, S., & Odhiambo, N. M. (2015). Economic Growth and Market-Based Financial Systems: A Review. Studies in Economics and Finance, 32(2), 235-255. Schulze, G. G., & Ursprung, H. W. (2002). International Environmental Economics: A Survey of the Issues. London: Oxford University Press. Williamson, J. G. (2006). Globalization and the Poor Periphery before 1950. Massachusetts: MIT Press. Read More