The Hecksher Ohlin Theory - Essay Example

Hecksher - Ohlin Theory The Hecksher - Ohlin theory explains international trade in terms of relative factor intensities. The basic idea behind thistheory was that while countries would have different endowments of factors of production, the difference could be offset by trade, thereby making the international mobility of factors unnecessary for economic development (ICFAI Center for Management Research (ICMR), 2005). In other words, the theory of comparative advantage assumes a single factor of production - labor - and describes a situation in which trade takes place between countries having different technologies, i.e., countries operating at different levels of efficiency, and therefore having certain comparative advantages. The Hecksher - Ohlin model developed by Eli Hecksher and Bertil Ohlin in the 1920s, explores the possibility of two nations operating at the same level of efficiency, benefiting by trading with each other. The H-O model incorporates a number of realistic characteristics of production that are left out of the simple Ricardo's model. Recall that in the simple Ricardo's model only one factor of production, labor, is needed to produce goods and services (Krugman, 1997). The productivity of labor is assumed to vary across countries, which implies a difference in technology between nations. It was the difference in technology that motivated advantageous international trade in the model (Suranovic, 2003). According to the Hecksher-Ohlin Theory, capital refers to the physical machines and equipment that is used in production. Thus, machine tools, conveyers, trucks, forklifts, computers, office buildings, office supplies, and much more, is considered capital. All productive capital must be owned by someone. In a capitalist economy most of the physical capital is owned by individuals and businesses. In a socialist economy productive capital would be owned by the government. In most economies today, the government owns some of the productive capital but private citizens and businesses own most of the capital. Any person who owns common stock issued by a business has an ownership share in that company and is entitled to dividends or income based on the profitability of the company. As such, that person is a capitalist, i.e., an owner of capital. This model makes the following assumptions: 1. There are no obstructions to trade i.e. no trade controls, transport costs etc. 2. Both commodity and factor markets are perfectively competitive. 3. There are constant returns to scale. 4. Both the countries have the same technology and hence operate at the same level of efficiency. 5. There are two factors of production - labor and capital. Both are perfectly immobile in inter-country transfers, but perfectly mobile in inter-sector transfers. According to this theory, there are two types of products - labor intensive and capital intensive. Two countries operating at the same level of efficiency can, and do, benefit from trade due to the differences in their factor endowments. The labor-rich country is likely to produce labor-intensive goods, while the country rich in capital is likely to produce capital-intensive goods. The two countries will then trade I these goods and reap the benefits of international trade. The Hecksher-Ohlin model has also got some drawbacks. First and foremost, it assumes that factor endowments remain constant but they can be developed through innovation (Jain, 2000). Second, with many countries imposing minimum wage laws, factor prices may change to an extent, that a labor-rich country may find it cheaper to import labor-intensive goods than to produce them locally. An economist named Wassily Leontief has pointed out that, the exports of United States were more labor-intensive than capital-intensive despite that fact that the United States is a capital-rich country. It is worth emphasizing here a fundamental distinction between the Hecksher-Ohlin model and the Ricardian model. Whereas the Ricardian model assumes that production technologies differ between countries, the Hecksher-Ohlin model assumes that production technologies are the same. The reason for the identical technology assumption in the H-O model is perhaps not so much because it is believed that technologies are really the same; although a case can be made for that. Instead the assumption is useful that it enables us to see precisely how differences in resource endowments is sufficient to cause trade and it shows what impacts will arise entirely due to these differences (Suranovic, 2003). The following paragraphs discuss in detail the empirical evidence and the extent to which they support the Hecksher-Ohlin theory. The advent of globalizations has definitely led to certain kinds of inequalities in trade both within and across countries. For a description of the impact of globalization on trade inequalities within and across countries, two model countries have been chosen - one being a rich-country and the other being a poor-country (Benek, 2006). The factor endowments of both the selected countries are that the former's capital-labor ratio is higher than the latter. The relative capital-abundance in the rich country leads to lower rent than in the poor country, which is relatively labour-abundant. If, in such a situation, free mobility of factors is introduced, capital will tend to flow from the rich country to the poor country to seek higher rent up to the point when rents in the countries get equal. On the other hand, workers will move from the poor country to the rich country where they will be better paid for their work. This will again happen until wages in both countries are equal. At the end of the day we have not only equal relative factor prices but also (due to capital mobility) equal capital-labour ratios. If there are barriers to factor mobility in both the selected countries, in the rich country the rent grew but the wages decreased, in the poor country the rent decreased but the wages rose. A different case might be when the capital-mobility controls are made to prevent the capital from flowing from the poor to the rich country. This will happen when return from capital is lower in the poor country than in the rich one. After abolishing capital-mobility barriers, the rich country will lure the poor country's capital, the rent will decrease, the labour will get relatively scarcer, and the wage will increase. On the other side capital will abandon the poor country; rent will rise and wage fall. As a consequence, rent in both countries will settle down at the same level, but wages will get even more unequal (Benek, 2006). Secondly, differences demand also cause a failure of predictions made by this theory. Leontief paradox shows that that capital intensive country might export labor intensive and import capital intensive goods. It seems to be in contradiction with HO model. There might be various explanations for that, but probably the most reasonable cause is so called "demand bias". Demand is an important aspect when discussing about trade (ICFAI Center for Management Research (ICMR), 2003). Unless the amount of demand is known, decisions cannot be taken on what products to produce, what products to import or export etc. Unfortunately, the Hecksher-Ohlin theory was not successful in addressing this aspect. Hecksher-Ohlin model displays us relative factor prices and combination of factors needed to produce certain amount of products. It is good for factor intensity analysis, but relative factor prices cannot be the same even when there is a change in the demand factor. HO model indicates how to be effective in producing when the factor needed are set. But the problem is that even though some country can be effective in producing something, demand for this good does not have to be there. For example, it can happen that demand for capital intensive goods in USA is so high that people consume these products and even import capital-intensive and on the other hand export labor intensive (Benek, 2006). The HO model would work if there are the same prices in the world. Then for example higher demand for cars would cause higher prices of cars, so the combination of factors needed to produce car worth of certain amount of money would shift inward. Then the country can lower wages, not produce cars or increase supply of cars to set off the changes. So a change in demand would causes different prices. But if in certain country is higher demand and domestic prices for a product than in other countries, it is not so easy anymore and it can cause the Leontief paradox. It will be good to consider a small country in this case, so that the change in demand in this country will not influence world prices. Then decreased demand in this country does not have to cause decrease in prices (if free trade is possible). Instead of giving up or lowering the production, country may produce the same amount of this good as before and export it out for the world prices. And it does not mean that the product exported has to be labor intensive or capital intensive. That is the reason, why demand is important in prediction, whether some country export or import capital/labor intensive goods. Empirical evidence on the Hecksher-Ohlin model has led to the following conclusions: - It has been less successful at explaining the actual pattern of international trade. - It has been useful as a way to analyze the effects of trade on income distribution. Bibliography 1. Benek, V. (2006). Heckscher-Ohlin Model. Blue Chips. 2. ICFAI Center for Management Research (ICMR). (2003). Economics for Managers. Hyderabad: ICFAI Center for Management Research. 3. ICFAI Center for Management Research (ICMR). (2005). International Marketing and International Business. Hyderabad: ICFAI Center for Management Research. 4. Jain, S. C. (2000). International Marketing Management. Delhi: CBS Publishers and Distributors. 5. Keerti, D. B. (2008, 02 02). Professor - ICFAI Business School. (R. V, Interviewer) 6. Krugman, P. (1997). The Strategy of International Business. International Business , 12-15. 7. Suranovic, S. M. (2003). The Hecksher-Ohlin Moderl Overview. Retrieved 02 23, 2008, from Internationa Trade Theory and Policy: http://internationalecon.com/Trade/Tch60/T60-0.php Read More