Intro-Proposer, Date, Book, Basic Idea

Assumptions
Explanation
1 Theory
2 Table
3 Diagram
Criticism
Applications

THEORY OF ABSOLUTE COST ADVANTAGE (Adam Smith)

Introduction:
Adam Smith the father of Economics propouded this theory in the year ---- in his
book--Adam Smith the first classical economist advocated the principle of absolute adv
antage as the basis of international trade.
Assumptions:
1. There are two countries A and B.
2. Both countries produce commodities X and Y.
Explanation:
Adam Smith exoltted the virtues of free trade. These are the result of the advan
tages of division of labor and specialization both at the national and internati
onal levels. The division of labour at the international level requires the exis
tence of absolute difference in costs. Every country should specialize in the pr
oduction of that commodity which it can produce more cheaply than others and exc
hange it for commodities which cost less in other countries.
According to Smith, "Whether the advantage which one country has over another be
natural or acquired,is in this respect of no consequence."
The countries A and B have absolute difference in cost in producing a commodity
each X and Y respectively, at the absolute lower cost of production than the oth
er.
The absolute difference in costs can be explained through the following table:
Absolute difference in costs:
Country

Commodity X 10
Commodity Y 5

5
10

The table reveals that country A can produce 10X or 5Y with one unit of labour a
nd country B can produce 5X or 10Y with one unit of labour.
In this, country A has an absolute advantage in the production of X (For 10X is
greater than 5X), and countrt B has an absolute advantage in the production of Y
(for 10Y is greater than 5Y). This can be expressed as:
10X of A divided by 5X of B is greater than one which is greater than 5Y of A di
vided by 10Y of B.
Trade between the two countries will benefit both if A specializes in the produc
tion of X and B specializes in the production of Y as is shown in table 2:
The above table reveals that before trade both countries produce only 15 units e
ach of the two commodities by applying one labour unit on each commodity. If A w
ere to specialize in producing commodity X and use both units of labour on it, i
ts total production will be 20 units of X. Similarly if B were to specialize in
the production of Y alone, its total production will be 20 units of Y. The combi
ned gain to both the countries from trade will be 5 units each of X and Y.
Figure 1 illustrates absolute difference in costs with the help of production po
ssibility curves. Y a X a is the production possibility curve of country A which
shows that it can either produce O X a of commodity X or O Y a of commodity Y.
Similarly country B can produce O X b of commodity X or O Y b of commodity Y. Th
e figure also shows that A has an absolute advantage in the production of commo
dity X, (since O X a is greater than O X b) and country B has an absolute advant
age in production of Y (since O Y b is greater than o Y a).
Criticism:
Smith has been critisized fir his vagueness and lack of clarity.
According to Ellsworth, Smith assume without arguement that a producer of export
s to have an absolute advantage, that is, an exporting country must be able to p
roduce with a given amount of capital and labour a larger output than any rival.
This basis of trade is not realistic since there are many underdeveloped cou
ntries that do not posess absolute advantage in the production of any commodity,
and yet they have trade relations with other countries.
RICARIDAN THEORY OF COMPARITIVE COSTS:
Introduction: According the
David Riccardo it is not absolute but comparitive differences in costs that lead
to trade relations between 2 countries. Production costs differ in countries be
cause of geographical distribution of labour and specialization in production. D
ue to differences in climate, natural resources, geographical situations and eff
iciency of labour. A country can produce one commodity at a lower cost than the
other. In this way, each country specializes in the production of that commodit
y in which its compatative cost of production is the least. Therefore, when a co
untry enters into trade with some other country,it will export those commodities
in which its comparative production costs are less and will import those commod
ities in which its comparative production costs are high. This is the basis of i
nternational trade, according to Ricardo.
It follows that each country will specialize in the production of those commodit
ies in which it has the greatest advantage or the least comparative disadvantage
. Thus a countrty will export those commodities in which its comparative advanta
ge is the greatest and import those commodities in which its comparative advanta
ge is the least.

ASSUMPTIONS OF THE THEORY:

The Ricardian theory of comparative advantage is based on the following assumpti
ons:
1. There are only two countries, say England and Portugal.
2. They produce the same two commodities say, wine and cloth.
3. There are similar tastes in both countries.
4. Labour is the only factor of production.
5. The supply of labour is unchanged.
6. All units of labour are homogenous.
7. Prices of two commodities are determined by labour costs, i.e., the number of
labour-units employed to produce each commodity.
8. Commodities are produced under the law of constant costs or returns.
9. Technological knowledge is unchanged.
10. Trade between the two countries takes place on the basis of the barter syste
m.
11. Factors of production are perfectly mobile within each country, but are perf
ectly immobile between countries.
12. There is free trade between the two countries, there being no trade barriers
or restrictions in the movement of commodities. 13. No transport costs are invo
lved in carrying trade between the two countries.
14. All factors of production are fully employed in both the countries.
15. The international market is perfect so that the exchange ratio for the two c
ommodities are the same.
EXPLANATION OF THE THEORY :
Given these assumptions, Ricardo shows that trade is possible between two countr
ies when one country has an absolute advantage in the production of both commodi
ties, but a comparative advantage in the production of one commodity than in the
other. This is illustrated in terms of Ricardo's well-known example of trade be
tween England and Portugal as shown in Table 3
Table 3: Man-Years of labour required for producing one unit.
England for wine 120 for cloth 100
Portugal for wine 80 for cloth 90
The table shows that the production of a unit of wine in England requires 120 me
n for a year, while a unit of cloth requires 100 men for the same period. On the
other hand, the production of the same quantities of wine and cloth in portugal
requires 80 and 90 men respectively. Thus England uses more labour than Portuga
l in producing both wine and cloth. In other words, the Portuguese labour is mor
e efficient than the English labour in producing both the products. So Portugal
posseses an absolute advantage in both wine and cloth. But Portugal would benefi
t more in producing wine and exporting it to England because it posseses greater
comparative advantage in it. This is because the cost of production of wine (80
divided by 120 men) is less than the cost of production of cloth (90 divided by
100). On the other hand, it is in England's interest to specialize in the produ
ction of cloth in which it has the least comparative disadvantage. This is becau
se the cost of production of cloth in England is less (100 divided by 90 men) as
compared with wine (120 divided by 80 men). Thus trade is beneficial for both t
he countries. The comparative advantage position of both is illustrated in Fig 2
.in terms of production possibility curves.
P L is the production possibility curve of Portugal and EG that of England. Port
ugal enjoys an absolute advantage in the production of both wine and cloth over
England. It produces OL of wine and OP of cloth, as against OG of wine and OE of
cloth produced by England. But the slope of ER (parallel to PL) reveals that Po

rtugal has a greater comparative advantage in the production of wine because if

it gives up the resources required to produce OE of cloth, it can produce OR of
wine which is greater than OG of wine of England. On the other hand, England had
the least comparative disadvantage in the production of OE of cloth. Thus Portu
gal will export OR of wine to England in exchange for OE of cloth from her.
Gains from trade and their distribution:
Ricardo does not discuss the exact ratio in which wine and trade would be exchan
ged and how much the two countries would gain from trade. Before trade the domes
tic trade ratios in the two countries for wine and cloth are shown in table 4. T
he cost of production of one unit of wine in England is 120 men and that of prod
ucing one unit of cloth is 100 men. It shows that the cost of producing wine is
more as against cloth because one unit of wine can be exchanged for 1.2 units of
cloth. On the other hand the cost of producing one unit of wine in Portugal is
80 men and that of producing one unit of cloth is 90 men. It is evident that the
cost of producing cloth is more than that of wine, since one unit of wine can b
e exchanged for 0.89 units of cloth.
Suppose trade begins between the two countries, England will gain if it imports
one unit of wine from Portugal in exchange for less than 1.2 units of cloth. Por
tugal will also gain if it imports one unit of cloth from England in exchange fo
r more than 0.89 units of wine.
The table shows that the domestic exchange ratio in England is one unit of cloth
= 0.83 units of wine, and in Portugal one unit of wine = 0.89 units of cloth. I
f we assume the exchange ratio between the two countries to be one unit of cloth
= one unit of wine, England would gain 0.17 (1 minus 0.83) unit of wine by expo
rting one unit of cloth to Portugal. Similarly, the gain to Portugal by exportin
g one unit of wine to England is 0.11, (1 minus 0.89) unit of cloth. Thus trade
is beneficial for both countries. The gains from trade are depicted in Figure 3
where the line C1W2 depicts the domestic exchange rate of 1 unit of cloth for 0.
83 units of wine of England, and the line W1C2 that of Portugal at domestic exch
age rate of 1 unit of wine = 0.89 units of cloth. The line C1W1 shows the exchan
ge rate of trade of 1 unit of cloth = 1 unit of wine between the two countries.
At this exchange rate England gains W2W1 (0.17 units) of wine, while Protugal ga
ins C2C1 (0.11 units) of cloth.
To sum up both England and Portugal specialize in the production of one commodit
y on the basis of comparitive costs. Each reallocates its resources accordingly
and exports that commodity in which it has comparitive cost advantage and import
s that commodity in which it has a comparitive disadvantage. Both gain through t
rade and can increase the consumption of the two commodities.
Criticism
1. Unrealistic assumption of labor costs: The most severe criticism of the compa
ritive advantage doctrine is that it is based on the labour theory of value. In
calculating cost of production, it only takes labour costs and neglects non-labo
ur costs involved in the production of commodities. This is highly unrealistic a
s it is money costs and not labour costs that is the basis of national and inter
national transactions of goods. Further, the labour costs theory is based on the
assumption of homogenous labour. This is unrealistic because labour is hetrogen
ous; of different kinds or grades, some specific or specialized while others are
non-specific or general.
2. No similar tastes: This assumption is unrealistic as tastes differ in differe
nt income brackets within the country. Moreover they also change with the growth
of an economy and the development of its trade relations with other countries.

3. Assumption of fixed proportions: The theory of comparitive advantage is based

on the assumption that labour is used in the same fixed proportions in the prod
uctions of all commodities. This is thus a static analysis and hence unrealistic
. In fact labour is used in varying proportions in the production of commodities
. Moreover some substitution of labour for capital is always possible in product
ion.
4. Constant Costs: The theory is based on another weak assumption that an increa
se of output due to international specialization is followed by constant costs.
But the fact is that there are either increasing or decreasing costs. If the lar
ge scale of production reduces the costs, comparitive advantage will be increase
d. On the other hand if increased output is a result of increased cost of produc
tion the comparitive advantage will be reduced, and it may even disappear.
5. Ignores transport Costs: Ricardo ignores transport costs in determining compa
ritive advantage in trade. This is unrealistic as transport cost play an importa
nt role in determining the patterns of world trade. Like economies of scale it i
s an independent factor of production.
6. Factors not fully mobile within the country: The doctrine assumes that the fa
ctors of production are perfectly mobile within the country and wholly immobile
internationally. This is unrealistic as even within the country factors do not m
ove freely from one industry to another and from region to another. The greater
the degree of specialization greater is the factor immobility from one industry
to another. Thus factor mobility affects costs and hence the pattern of internat
ional trade.
7. Two-Country Two-Commodity model unrealistic: The Ricardian model is related t
o trade between 2 countries based on 2 commodities. This is unrealistic as in th
e real world there are many countries engaged in trading many commodities.
8. Free Trade: Another serious problem with the doctrine is that it assumes perf
ect and free world trade. But in reality, world trade is not free. Every country
applies restriction on the movement of goods to and from other countries. Thus
tariffs and other trade restrictions affect world imports and exports. Moreover
products are not homogenous but differentiated. Ignoring these factors makes Ri
cardian theory weak.
9. Full Employment: Like all classical theories this theory is also based on the
assumption of full employment. This makes the theory static. Keynes falsified t
he assumption of full employment and proved that under-employment exsists in the
economy.
10. Self Interest Hinders its Operation: This doctrine does not work if a countr
y having a distinct comparitive disadvantage does not wish to import a commodity
from the country due to strategic millitary or development considerations. Thus
often self interest stands in the way of the operation of the theory of omparit
ive advantage.
11. Neglects Role of Technology: The theory neglects the role of technoligical i
nnovations in international trade. This is unrealistic as technological changes
increase the supply of goods not only in the domestic market but also in the int
ernational market. World trade has gained much from innovations and research and
development.
12. One-Sided Theory: It is a one sided theory as it considers only the supply s
ide and ignores the demand side. In the words of Ohlin, "It is nothing more than
the abbreviated account of the condition of supply".
12. Imposibility of complete Specialization: Prof. Frank Graham has pointed out

that complete specialization will be impossible on the basis of comparitive adva

ntage in producing commodities entering into international trade. He explains tw
o cases in support of his arguement: one relating to a big country and a small c
ountry and two relating to a commodity of high value and low value. In case one,
suppose two countries engage in trade based on comparitive advantage; one a big
country and the other a small one. The small country will be able to specialize
completely as it can dispose of its surplus commodity to the bigger one. But th
e big country will not be able to specialize completely because:
1. being big, the small country will not be able to meet its requirements fully
2. if it specializes completely in one commodity its surplus will be so large th
at the smaller country will not be able to import all of it.
In the second case of commodities having incompareable value, the country produc
ing in high value commodity will be able to specialize while the one producing t
he low value good will not be able to do the same. This is becaus the former cou
ntry will be in a position to have larger gain than the latter country. Thus, ac
cording to Graham, "The classical conclusion of complete specialization can hold
good only.... by assuming that trade is between two countries of approximately
equal performance."
14. A Clumsy and Dangerous Tool: Prof. Ohlin criticises this theory on the follo
wing basis:
1. The principle of comparitive advantage is not applicable to international tra
de alone, rather it is applicable to all trade. To Ohlin, "International trade i
s but a special case of inter-local or inter-regional trade."
2. Factors are immobile not only internationally but also within different regio
ns of the same country. This is proved by the fact that wage rates and interest
rates differ in different regions of the same country. Further labour and capita
l can also move internationally in a limited way, as they do within a country.
3. it is a 2 country 2 commodity model based on the labour theory of value, whic
h is sought to be applied to actual conditions involving many countries and comm
odities. He therefore, regards the theory of comparitive advantage as cumbersome
, unrealistic, and as a clumsy and dangerous tool of analysis.
15. Incomplete Theory: The theory simply explains how two countries gain from in
ternational trade. But it fails to show how the gains are distributed among the
two countries.
Conclusion:
Despite these weaknesses, the theory has stood the test of time. Its basic struc
ture has remained the same even though many refinements have been made over it.

HECCHER-OHLIN THEOREM
Introduction:
Bertin Ohlin in his book- 'Inter-regional and International trade (1933), critis
ized the classical theory of International Trade and formulated the General Equi
librium or Factor Endowments or Factor Proportions Theory of International Trade
.
Heckscher propounded the theory in 1919 stating that it was differences in facto

r endowments that result in international trade, Ohlin his student later carried
forward this theory.
The H.O. theory states that the main determinant of pattern of production, speci
alization and trade among regions is the relative availability of factor endowme
nts and factor prices. Regions or countries have different factor endowments and
factor prices. "Some countries have much capital and others have much labour. T
he theory now says that countries that are rich in capital will export capital i
ntensive goods and countries that have much labour will export labour-intersive
goods." To Ohlin, the immediate cause of international trade always is that some
commodities can be bought more cheaply from other regions whereas in the same r
egion their production is possible at high prices. Thus the main cause of trade
between regions is the difference in prices of commodities based on relatively f
actor endowments and factor prices.
Assumptions:
1. It is a two-by-two-by-two model; i.e., there are 2 countries (A and B), 2 com
modities (X and Y) and 2 factors of production (capital and labour).
2. There is perfect competition in both factor and commodity market.
3. There is full employment of resources.
4. There are differences in factor endowments in different regions, but qualitat
ively they are homogenous.
5. The production functions of the two commodities have different factor intensi
ties, i.e., labour-intensive and capital-intensive.
6. The production functions are different for different commodities, but are the
same for each commodity in both country. It means that the production function
of X is different from Y. But the technique used to produce commodiy X in both c
ountries is the same, and the technique used to produce Y in both countries is t
he same.
7. Factor intensities are non-reversible.
8. There is perfect mobility of factors within a region but they are internation
ally immobile.
9. There are no transport costs.
10. There is free and unrestricted trade between the countries.
11. There aer constant returns to scale in the production of each commodity in e
ach region.
12. Tastes and preferences of people and their demand patterns are identical in
both countries.
13. There are no changes in technological knowledge.
14. There is incomplete specialization. Neither country specializes in the produ
ction of one commodity.
EXPLANATION:
Given these assumptions Hecksher and Ohlin contended that the immediate cause of
international trade is the differences in commodity prices caused by difference

s in relative demand and supply of factors (factor prices) as a result of factor

endownments between the two countries. Fundamentally the relative scarcity of f
actors; the shortage of supply in relation to demand; is essential for trade bet
ween two countries. Commodities which use large quantities of scarce factors are
imported because their prices are low.
The H.O Theorem is explained in two definitions
1. Factor abundance (or scarcity) in terms of Factor Price: Hecksher Ohlin expla
ined richness in factor abundance in terms of factor price. According to them co
untry A is abundant in capital if (Pc upon P L)A is less than (PC upon P L)B. Wh
ere PL and PC refer to prices of labour and capital respectively and subscripts
A and B denote the 2 countries. In other words, if capital is relatively cheap i
n country A, the country is relatively abundant in capital and if labour is rela
tively cheap in country B it is labour abundant. Country A will produce and expo
rt capital intensive goods and import the labour intensive good and cuntry B wil
l produce and exprot the labour intensive goods and import the capital intensive
one. This is shown in the figure.
Let X be the labour intensive good taken on the horizontal axis and Y be the cap
ital intensive good taken on the vertical axis. XX is the isoquant of commodity
X and YY that of good Y. They are the same for both countries A and B. The relat
ive factor prices in country A for both the commodities are given by the factor
price line AA1. Assuming that each isoquant represents 1 unit of each commodity,
then 1 unit of Y will be produced with OC amount of capital OD amount of labour
at point E where the isocost line AA1 is tangent to the isoquant YY. By the sam
e reasoning we find that the cost of producing 1 unit of X in country A is OM of
capital and O N of labour. Since Capital is cheaper in country A it will specia
lize in the production of capital intensive commodity Y. This is clear in the fi
gure where in order to produce 1 unit of Y it uses more amount of capital OC tha
n labour OD at E of the isoquant YY. While at point L of isoquant XX it uses les
s amount of capitla OM with more of labour O N in order to produce 1 unit of X.
Hence country A will produce and export the relatively capital intensive and che
ap commodity Y to the other country B.
In order to find the cost of producing one unit of each commodity in country B w
here labour is relatively cheap and abundant we draw a flatter factor price line
BB3 tangent to isoquant YY at point G. A similar flatter factor price line B1B3
is drawn parallel to isocost line BB3 which is tangent to the isoquant XX at po
int S. Now it takes OK amount of capital and O H amounts of labour in country B
to produce one unit of commodity Y, and OT and O R amounts of capital and labour
respectively to produce one unit of X. Since labour is cheap and abundant in co
untry B it will specialize in the production of labour intensive commodity X. So
it will produce at point S on the isoquant XX, where it requires more amount of
labour O R with less amounts of capital OT than commodity Y which requires less
amounts of labour O H with more amounts of capital OK at point G on YY. Hence c
ountry B will export commodity X to country A in exchange for commodity Y.
2. Factor abundance (or scarcity) in terms of physical criterion
Another way to explain the H.O. theorem is in physical terms of factor abundance
. According to this criterion, a country is relatively capital abundant if it is
endowned with a higher proportion of capital and labour than the other country.
If country A is relatively capital abundant and B is relatively labour abundant
then measured in physical amounts CA upon LA is greater than CB upon L B. Where
CA and LA are the total amounts of capital and labour in the country A and CB a
nd L B are the total of capital and labour in country B. This is explained in th
e figure where AA1 is the production possibility curve of country A and BB1 that
of country B. The slopes of these curves show that commodity Y is capital inten
sive and X is labour intensive. If both countries produce both commodities in th

e same proportion they will produce along the ray O R. When both produce along t
heir respective points, A will produce at point E where the factor price line ST
touches the PPC AA1. It will produce more of commodity Y (that is OS) which is
cheaper in it and less (OT) of commodity X which is dearer in it. Country B will
produce at point F where the factor price line KQ touches the PPC BB1. It will
produce more (OQ) of commodity X which is cheaper in it and less (OK) of commodi
ty Y which is dearer. This is proved by factor price line S T of country A which
is steeper than than the factor price line KQ of country B which is flatter.
The difference between both factor price lines TQ on the X axis indicates that O
Q of commodity X is produced more in country B relative to OT quantity in count
ry A. Similarly difference between both factor price lines KS on Y axis shows th
at OS of commodity Y is produced more in country A relative to OK quantity of Y
in country B.
Thus the capital abundant country A has a bias towards producing the capital int
ensive commodity Y and the labour abundant country has a bias towards the labour
intensive commodity X.
Criticisms:
1. 2 by 2 by 2 Model: Ohlin has been criticised for the 2 by 2 by 2 model based
on oversimplified assumptions. However Ohlin points out that it can be extended
to many countries, commodities and factors.
2. Static Theory: Like the classical theories the H.O. Model is static in nature
. "It only gives some characteristics of the country at a given point of time. F
or instance it can give information on how to rank a good at any given moment, h
owever it does not give any indication as to how the economy would develop if pr
oduction conditions were to change.
3. Homogenous Factors: The theory assumes the exsistence of homogenous factors i
n the two countries which can be measured for calculating factor endownment rati
os. But in reality, no two factors are homogenous qualitatively and one factor m
ay as well be of many different types. Labour both skiled and unskilled may be o
f many types. Similarly capital may take many form and may act in a labour savin
g manner.
4. Production Techniques not Homogenous: There is no Homogenity in the productio
n techniques of the same commodity in two countries. For Example: Textile may be
produced by handlooms (requiring labour and little capital) or powerlooms (requ
iring little labour and large capital). In such situations trade may not follow
the H.O model.
5. Tastes and Demand Ptterns not identical: This assumption imples that tastes a
nd demand patterns are the same for different income groups, which is unrealisti
c. Moreover due to innovations in consumer goods changes do occur in demand patt
erns even in developed countries.
6. No constant Returns: A country that has rich factors of production often reap
s the benefits of economies of scale through less production and exports. Thus t
here are increasing and not constant returns.
7. Transport Costs influence Trade: When transport and port costs like loading a
nd unloading costs are added they lead to price difference between the 2 countri
es for the same product. This affects their trade relations.
8. Assumptions of Full Employment and Perfect Competition are unrealistic.
9. Leontief Paradox Falsified this Theory: H.O. theorem assumes that the factor
price is a direct representative of factor endownments. This may be true from th

e supply side. But if wwe consider the demand side, a country may produce labour
intensive goods due to the high demand of labour intensive products in the mark
et despite the cost of labour being relatively higher as compared to capital.
10. Partial Equilibrium Analysis:
11. Factor Prices do Not Determine Commodity Prices: Wijanholds states that the
price of a commodity is based on its utility. Subsequently the prices of factors
are based on the final prices of the commodity rather than the other way around
.
12. Vague and Conditional Theory.
RYBCZYNSKI THEORREM
The H.O Theory is based on the assumption of constant factor endowments. Rybczyn
ski depicted in a paper published in 1955 the effects of changes in one factor w
hile keeping the other constant on the output of the 2 commodities entering into
international trade. The Rybczynski theorem states that in a 2 factor 2 commodi
ty economy a rise in the supply of one factor, keeping the supply of the other f
actor constant, leads to an increase in the output of that commodity which uses
the increased factor more intensively, and a decline in the output of the other
commodity. For instance, if the supply of labour increase the output of the labo
ur intensive increases and the output of the capital intensive commodity decreas
es. On the contrary if the supply of capital increases the output of capital int
ensive commodity increases and that of the labour intensive commodity declines.
Assumptions
1. There are 2 countries which trade with each other. But the analysis is geomet
rically confined to one country.
2. This country produces only 2 commodities, X and Y.
3. These commodities are produced using 2 factors, labour and capital.
4. These two factor are perfectly divisible, perfectly mobile and substituteable
to some degree.
5. The production fucntions of the 2 commodities are different. Commodities are
linear and homogenous.
6. The factor intensity of each commodity is different.
Commodity X is relatively labour intensive and Y is relatively capital intensive
.
7. Both commodity and factor prices are constant.
8. There is perfect competition in commodity and factor markets.
9. Only the supply of one factor is changed while keeping the other constant.
Explanation
Given these assumptions the Rybczynski theorem can be explained with the help of
the box diagram where the origion of commodity X production is O and the origio
n of commodity Y production is O1. The countries original factor endowments are
measured by the OCO1L. On this box labour is measured on the horizontal axis and
capital on the vertical axis. Suppose A is the initial production point lying o

n the contract curve OAO1, such that the capital labour ratios for each commodit
ies are given by the OA and O1A. The slope of OA shows that commodity X (on the
horizontal axis) is labour intensive relaive to commodity Y. Similarly the slope
of O1A shows that commodity Y is capital intensive relative to commodity X. OA
also reflects the output of X and O1A that of commodity Y. OL is the supply of
labour and OC the supply of capital. Suppose the supply of labour increases from
OL to OL1. With the increase in labour LL1 the new box is OL1O2C. Since the cap
ital labour ratio in each commodity is unchanged at constant price, the new prod
uction point is at A1, which lies on the extention of of ray OA and the new ray
O2A1 drawn parallel to O1A. The new production point A1 which lies on the contra
ct curve OA1O2 shows that the output of the labour intensive commodity X has inc
reased from OA to O1A, and the putput of capital intensive commodity Y declines
from OA to O2A1.

THE LEONTIEF PARADOX:

The first comprehensive attempt to verify the H.O. model was made by Wassily Leo
ntief in 1953. The H.O.theory states that relatively capital-abundant country wi
ll export the relatively capital intensive goods, and it will import the goods i
n whose production relatively large amounts of its relatively scarce factor labo
ur are required. Leontief in his study reached the paradoxial conclusion that th
e United States which possess a relatively large amount of capital and a relati
vely small amount of labour in relation to the rest of the world, exported labou
r-intensive goods and imported capital-intensive goods. The result has come to b
e known as the Leontief Paradox.
Leontief started his test of the H.O prediction that the United States would exp

ort its abundant factor capital in commodity form and import its scarce factor l
abour in commodity form. To test this prediction, Leontief used the 1947 input-o
utput table of the U.S. economy. He aggregated 200 groups of industries into 50
sectors, of which 38 traded their products directly on the international market.
He took 2 factors, labour and capital. He estimated the capital and labour requ
irments for production of one million dollars worth of United States exports and
also one million dollars worth of United States imports-competing commodities.
Leontief's main empirical results are summarized in Table 1.
Table 1: Capital and Labour requirments in per million dollars of U.S. export an
d import.
Leontief found that U.S. exports used a capital-labour ratio of $ 13,911 per man
-year, whereas imports replacements (substitutes) used a capital-labour ratio of
$ 18,185 per man-year. Thus his results showed that capital-labour ratio in U.S
. import-replacement industries was 20% higher than the U.S export industries. I
t means that in the U.S. import-competing industries are relatively more capital
-intensive than the export industries. As Leontief stated; "America's participat
ion in the international division of labour is based on its specialisation on la
bour intensive rather than capital intensive, lines of production. In other word
s the country resorts to foreign trade in order to economise in its capital and
dispose of its surplus labour, rather than viseversa." Given the production that
the United States is relatively capital-abundant, it exports labour-intensive g
oods. This is just contrary to the H.O theorem. Thus it is called the Leontief's
Paradox.
Criticisms:
1. 1947 not a typical year: Swerling did not consider the year 1947 as a typical
yearfor testing the H.O. model because the post war disorganization of producti
on had not been corrected in the world by that year. Moreover the United States
was the only major industrial economy free of devastation of war. Thus the Leont
ief study was basically a description of the USA's trade in the year 1947.
2. Problem of Aggregation: Balogh criticised aggregation in the input-output mat
rix for computing indirectly capital-labour ratios. As a result the labour inten
sities of the USA's export industries might be spurious and attributeable to the
aggregation of capital-intensive exportable products with similar non-export, l
abour-intensive activities.
3. Incompatibility of Input-Output Model: Valvaris-Vail objected to the Leontief
test on the grounds that "input output models (except with the rare luck) was l
ogically incompatible with intenational trade. He argued that the Leontief model
with its fixed input coefficients, was incompatible with a world trade equilibr
ium in which each country gained from trade, full employment exsisted and the in
troduction of trade increased the output of some commodities and reduced that of
others.
4. Low Capital-Labour Ratio countries: Swerling criticized Leontief for includin
g industries with a low capital labour ratios. Such industries were fisheries, a
griculture and services like transport, wholesale trade etc. These biased his re
sults.
5. Consumption patterns: The Leontief Paradox does not take into consideration t
he impact of consumption patterns on the imports and exports of USA. According t
o Romney Robinson, the demand patterns in a country might be so biased towards t
he consumption of a commodity that it may produce it with a relatively abundant
factor. As per capita income increases the consumption may be biased towards lab
our-intensive or capital-intensive products.

6. Durability of Capital: Bauchanan critisized Leontief for using "investment re

quirements coefficients" as capital coefficient in his study. He, therefore fail
ed to take into account the durability of capital in various industries.
7. Tariffs ignored: Travis argued that tariffs often distorted the pattern of tr
ade and thus, reflected relative factor endownments of a country. On this basis
the Leontief test was seriously affected by USA and foreign tariffs.
8. Neglect of Natural Resources: Bauchanan criticised Leontief for ignoring natu
ral resources which were critical in determining trade patterns.
9. Comparision of Capital Intensity Irrelevant: Ellsworth pointed out that the c
apital intensity of the USA's import substitutes was ittelevent to the comparisi
on. What is required is a comparision of the capital intensities of USA's export
s with the capital intensities of exports of other countries to the United State
s. Since the USA is a capital intensive country the goods produced by it to repl
ace imports must be capital intensive. This is what Leontief arrived at in case
of import replacements. But he should have studied whether the goods imported in
to the USA were capital or labour intensive in the country of origin.
10. Labour Productivity: Leontief argued that the United States was relatively
labour intensive. This was because Leontief considered the labourer in the USA t
o be much more productive than other countries; three times more, according to h
im. This has been critisized by Ellsworth as 'conceptual awkwardness' and Bhagwa
ti questioned the means as to how Leontief arrived at said conclusion.
11. Neglects Human Capital: Leontief only includes physical capital and ignores
human capital. Kenen noted that the Leontief paradox was reversed when value of
human capital was added to the test results.
12. Unbalanced Trade: Leamer found that the Leontief Paradox failed when trade w
as unbalanced. When he examined USA's trade in 1947, the USA had a trade surplus
and there was no evidence of of the Leontief Paradox that its exports were rela
tively labour intensive.
13. Factor Intensity Reversals: Leontief has been criticised for taking only one
country in his study. If he had taken a second country like Japan he would have
found USA's exports capital intensive as compared with the Japanese exports.

INTRA INDUSTRY TRADE:

The Classical, H.O. and other models, explain inter-industry trade between 2 cou
ntries. Inter-Industry trade is when a commodity of one industry is exchanged fo
r a commodity of a different industry. Inter-Industry international trade is bas
ed on the assumption of perfect competition. On the other hand, intra-industry i
nternational trade is the trade within an industry in differentiated products wh
ich are similar but not identical. For Example: German Cars are traded for Frenc
h Cars etc.
With product differentiation, when countries with substantial cost differences p
roduce and trade all varities of different products, it is inter-industry trade.
But when countries without substantial cost differences specialize at the indus
try level and trade, it is known as Intra-industry trade.
Intra-industry trade is due to specialization and increased division of labour w
hich is dependent on the size of the market. Economic growth and Globalization
have led to the increase of Intra-industry trade in intermediate and finished go

ods. Also it has increased as border trade due to high transport cost and season
al trade due to high storage costs of fruits and vegetables etc.
When 2 firms in 2 countries have a monopoly in the production of a similar produ
ct the opening up of trade between then leads to competition which will reduce p
rices and profits but leads to gains for the customers in both countries.
In the situation of monopolistic competition in the countries, Intra-industry tr
ade makes available large varieties of products in both countries. With the expa
nsion of trade, producers are able to reap the benefits of economies of scale. a
nd thus reduce the cost and subsequebtly prices of the commodities. Some produce
rs may stop production and exit the industry. Thus both countries benefit from I
ntra-industry trade when cheap and quality products are available. Secondly with
product differentiation, a small country can undersell a large country through
economies of scale and specialization. Thirdly, there is an increase in the volu
me of trade between two countries of similar size and factor endownments. Lastly
, Product differentiation based trade leads to increase in parts and components
production along with their assembling in different countries to reduce costs. T
his leads to sharp increase in such intermediate commodities specially by MNCs.