The Heckscher-Ohlin Theory

In 1919 Eli Heckscher a Swedish economist published an article The Effect of Foreign Trade on the Distribution of income. Which was the modern theory of international trade Later his student Bertil Ohlin another Swedish economist worked together to make the Heckscher-Ohlin Theory. This stated that, A nation will export the commodity whose production requires the intensive use of the nations relatively abundant and cheap factor and import the commodity whose production requires the intensive use of the nations relatively scare and expensive factor. In other words the relatively labor-rich nation exports the relatively labor-intensive commodity and imports the relatively capital -intensive commodity. This means that Nation 1 exports X because X is the Labor intensive commodity and L is relatively abundant and cheap factor in Nation 1. The theory was made to explain the comparative advantage as we assume it in the classical theories A few assumptions were made to the theory The Assumptions to the Heckscher-Ohlin Theory 1. There are two nations (1&2), two commodities (X&Y), two factors of production (labor & capital). 2. Both nations use the same technology in production, means both nations have access to and use the same general production techniques. 3. Commodity X is labor intensive and Y is capital intensive in both nations. -Means the labor-capital ratio (L/K) is higher for X than Y in both nations at the same relative factor prices. 4. Both commodities are produced under constant returns to scale in both nations. Means that increasing the amount of Labor and Capital will increase output in the same proportion

5. There is incomplete specialization in production in both nations, means that even with free trade both nations continue to produce both commodities. This implies neither nation is very small. 6. Tastes are equal in both nations, means demand preferences are identical in both nations. When relative prices are equal in the two nations, both consume X&Y in the same proportion. 7. There is perfect competition in both commodities and factor markets in both nations. Means that producers, consumers, and traders of X&Y in both nations are each too small to affect prices of commodities. 8. There is perfect factor mobility within each nation but no international factor mobility. Means Capital and Labour are free to move from areas and industries of lower earnings to those of higher earnings until earnings are the same in all areas, uses and industries of the nation. International differences in earnings persist due to zero international factor mobility in the absence of international trade. 9. There are no transportation costs, tariffs, or other obstructions to the free flow of international trade. 10. All resources are fully employed in both nations, means there are no unemployed resources in either nation. 11. All resources are fully employed in both nations.

Criticism of Heckscher-Ohlin's Theory The following points of criticism have been offered against Heckscher-Ohlin's factor proportion theory: He did not analyse the real commercial labor and capital content of imports (eg from LEDCs) but rather the labor and capital of the domestic (USA) equalivance of these inputs He did not distinguish different types of labor which were skilled and unskilled Ohlin's theory is criticized on the ground that since it is based on over-simplified assumptions, it is unrealistic. But as against this it may be pointed put that the simplified assumptions were made to make it easily understandable; otherwise the theory holds good even in situations where these assumptions are absent. Haberler has pointed out that although Ohlin's theory is more realistic, yet it remains a partial equilibrium analysis. He has failed to develop a comprehensive general equilibrium analysis. One assumption underlying Ohlin's theory is that relative factor prices reflect relative factor endowments. This gives undue importance to supply and attaches less importance to demand. Also, it may be pointed out that if demand conditions are given due weight, the commodity price ratios may not correspond to cost ratios. The critics have also urged that differences of relative factor endowments (which is the very basis of Ohlin's theory).are only one of the several explanations for the commodity price differences of the internationally-traded goods. Differences in production techniques or in factor qualities, consumers' demand, etc., are also important in this connection. It is also said that the prices of commodities are not determined by factor costs, but it is the other way about. That is, the prices of the factors of production (e.g. the raw materials) are determined by the prices of final goods offered by the consumers.

Leontief Paradox The first serious attempt to test the Heckscher-Ohlin Theory was made by Professor Wassily W. Leontief in 1951. Since it was assumed that US will be capital intensive and would be importing Labor intensive commodities using the 1947 trade date of US and his results of the test were startling as the US import substitutes were about 30% more capital intensive than the exports and exported more labor intensive commodities. As a result Leontief reached a paradoxical conclusion that the US is most capital abundant country in the world by any criterion, exported labor-intensive commodities and imported capital- intensive commodities. This result has come to be known as the Leontief Paradox. [para = contrary to, doxa = opinion] He aggregated industries into 50 sectors, but only 38 industries produced commodities that enter the international markets, and the remaining 12 sectors were created for accounting identities and nontraded goods. He also aggregated factors into two categories, labor and capital. He then estimated the capital and labor requirements to produce: One million dollars' worth of typical exportable and importable bundles in 1947.

Capital Requirement Exports aKx = 2,550,780

Labor Requirement aLx = 182,313 man-years

Imports

aKm = 3,091,339

aLm = 170,114 man-years

kx = aKx/aLx = $14,300 (exports) capital-labor ratios km = aKm/aLm = $18,200 (imports)

Hence the ratio of imports to exports= 18,200/14,300 = 1.30 using the data of 1947 trade in US.
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Leontief tried to rationalize and supported the H-O theory as he had argued that there was an optical illusion since in 1947 US was 3 times as productive as foreign labor. This explanation was said to be not acceptable so he withdrew it. Later on Leontief repeated his tests which he believed was bias because it was too close to the World war 2 to be represented so he repeated the tests using the trade data of US economy 1951 Capital Requirement Exports aKx = 2,256,800 Labor Requirement aLx = 174,000 man-years

Imports

aKm = 2,303,400

aLm = 168,00 man-years

kx = aKx/aLx = $13,000 (exports) capital-labor ratios km = aKm/aLm = $13,726 (imports)

Hence the ratio of imports to exports= 13,000/13,726 = 1.06 using the data of 1951 trade in US. This showed that the trade close to equilibrium between the imports and exports but it still ment that US was slight labor intensive, and after calculating without natural resource industries the ratio fell further more to 0.88 which eliminates the paradox because the ratio was below 1 meaning that US imported more Labor intensive than capital intensive proving the H-O theory correct. This was because in 1965 Kenen excluded the natural resource content to prove the theory wrong.

Conclusion
Logical the H-0 theory shows that its is correct when trying to prove comparative advantage, while the Leontief paradox bases its research test only on USA, the first test by Leontief was made with the data affected by the world war 2 which showed that the US was Labor intensive and was exporting more Labor intensive commodities Also another factor, a more general source of bias is that Leontief used two-factor model (abour and capital), thus abstracting from other factors such as natural resources (soil, climate, minerals). However the commodity might be intensive in either of the 2 factors. US trade policy was also another factor that was a source of bais in the Leontief study, in 1956 Kravis found that the most heavily protected industries in the US were the Labor intensive industries. Another bias source of Leontief was the fact that he included the measure of capital, only physical capital such as machinery, and completely ignored Human capital. The influence of Research and development on US exports, the knowledge capital resulting from R&D leads to an increase in the value of output derived from a given stock of material and human labor which was not considered by Leontief. Although these theories provide a general explanation of why nations trade, they have been criticised on several grounds: Nations do not initiate trade: this is done by individuals or individual firms within nations. There must be perfect information and perfect competition between trading partners, which is never the case. They are limited because they do not look at either the transfer of goods or direct investments. They do not recognise the influence of technology and expertise in the areas of marketing and management.

They are many other theories that are involved in arguing against the H-O and Leontief paradox theory, but it seems like the H-O theory is much more expected by the economist rather than the Leontief theory.