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ECON 471 SUMANT RAI

4. Post Heckscher-Ohlin Trade Theories

In this section, we will first look at the empirical validity of the H-O model and then we will
explore the newer trade theories.

4.1 Empirical Testing of H-O Model

HO Theorem: If country I is K-abundant and good X is K-intensive, then HO theorem predicts


that country I will export good X (K-intensive) and import good Y (L-intensive) while country II
will import good X and export good Y.

The literature has produced some conflicting results on the validity of HO theorem.

4.1.1 The Leontief Paradox

HO theorem → K/L ratio of the exported good must be greater than the K/L ratio of the
( )
imported good. That is, ( ) ( )
( )

Leontief, using 1947 data, looked at the K/L of the goods exported by the US and the K/L ratio
of the goods imported (K/L ratio that would be required if the imported good was produced in
the US – import substitution).

( )
He found that is approximately 1.3 contrary to the prediction of the H-O theorem
( )

(should have been less than 1).

What it means is that US exports consisted more L-intensive goods, which is in contradiction
with the prediction of HO theorem since US is considered to be K-abundant country. Therefore,
his study is known as ‘Leontief Paradox’.

( )
is called Leontief statistics.
( )

4.1.2 Suggested Explanations for the Leontief Paradox

a) Demand Reversal: Recall that in the presence of demand reversal, trade does not follow the
H-O pattern when the physical definition of relative factor abundance is used (see section 3.4.6).
The validity of demand reversal as an explanation of the Leontief paradox is an empirical
question. However, considerable dissimilarity (very unlikely to be true in practice) is required
for the demand reversal explanation to be a good explanation in understanding the paradox.

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b) Factor Intensity Reversal: FIR occurs when a good is produced in one country by relatively
K-intensive methods but is produced in another country by relatively labor intensive methods
→ the prediction of HO model is only half valid. Therefore, there is a possibility that the trading
partner (L-abundant country) would conform to HO by exporting L-intensive good (which is
produced with K-intensive method in the US). The validity of this explanation is also an
empirical question. The empirical literature is somewhat divided on the matter of whether
factor intensity reversal occurs with any frequency, and we cannot rule them out altogether.

Test for FIR: The most famous test was conducted by B. S. Minhas (1962) for the US and Japan
using 1947 and 1951 data for 20 industries. He ranked K/L ratio in each country in descending
order for all 20 industries. If there is no FIR, then the two rankings are identical in both
countries or the correlation coefficient would be 1, it would be -1 when there is complete FIR
and would be 0 if there is no association between the two rankings. Minhas obtained a rank
correlation of only 0.328. For direct factor requirements, the coefficient was 0.73. Thus, doubt
can be cast on no FIR assumption of HO model. G. C. Hufbauer (1966) and D. S. Ball (1966)
pointed out that, under some conditions, the rank correlation coefficients are much closer to 1.
Thus, while there have been some suggestion of FIR, but it may not be sufficient to explain
Leontief paradox.

c) U.S. Tariff Structure: H-O and S-S theorem suggest that the opening of a country to trade
increases the real return of the abundant factor and reduces the real return of the scarce factor
→ labor will argue for protection → trade barrier would result in the restriction of L-intensive
goods being imported → the composition of US import bundle would be relatively more K-
intensive than would otherwise be the case. Robert Baldwin (1971) estimated that the K/L ratio
in US imports would be 5% lower if this effect was incorporated. Thus, allowance for tariff
reduces the extent of the paradox but is unable to completely remove it.

d) Different Skill Level (Human Capital): Using labor as a factor of production may be too
aggregative because there are different skill levels of workers. Using this idea, Donald Keesing
(1966) divided labor into 8 different categories (category I being the most skilled and category
VIII being the least skilled workers). He found that US exports consist of a higher percentage of
category I workers and smallest proportion of category VIII workers. Similarly, smallest fraction
of category I and largest fraction of category VIII workers were used in US imports. Therefore, it
seems that paradox exists because of two factors used for the test. Perhaps, US is not only K-
abundant but also skilled labor abundant. Other tests also confirmed Keesing’s general
impression and it was suggested to go beyond two factor model to test whether the US trade
pattern conforms to H-O.

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e) Natural Resources: This is based on the additional factor, natural resources (two-factor test is
too restrictive). In the context of Leontief Paradox, many goods labeled as K-intensive might
actually be natural resource intensive. For example, petroleum uses a great deal of natural
resources in addition of capital. The importance of natural resources has been confirmed in
some empirical tests. James Hartigan (1981) concluded that the paradox exists in general, but
not when natural resource intensive industries were excluded from the test. Leontief (1956)
himself discovered that adjustment for natural resources could reverse the paradox. However,
Baldwin (1971) found that it reduced the extent of the paradox but did not eliminate it.

4.2 Weaknesses of H-O Model

 It ignores the existence of intra-industry trade


 A large fraction of world trade is among developed countries rather than between
developed and developing countries
 A significant percentage of world trade is carried out by large corporations (monopolists
and oligopolists).

4.3 Post Heckscher-Ohlin Trade Theories

This section considers the most recent theories on the causes and consequences of trade by
relaxing several assumptions employed in the basic trade models.

4.3.1 The Imitation Lag Hypothesis

This theory was introduced by Michael V. Posner in 1961. This theory is introduced here only to
the extent it paves the way for a better known theory – the production cycle theory. It relaxes
the assumption of H-O model that the same technology is used everywhere. It assumes that the
same technology is not always available in all countries but there is a delay in the diffusion of
technology from one country to another.

Suppose that country I develops a new product due to the successful effort of R&D. According
to this theory, this new product will not be produced immediately by firms in country II.
Incorporating a time dimension, the imitation lag is defined as the length of time (say, 15
months) that elapses between the product’s introduction in country I and the appearance of its
version produced by firms in country II. The imitation lag includes a learning period (country II
must acquire technology and know-how in order to produce the product), time to purchase
inputs, install equipment, process the inputs, bring the finished product to market and so on.

In this process, a second adjustment lag is the demand lag, which is the length of time between
the product’s appearance in country I and its acceptance by consumers in country II as a good

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substitute for the product they are already consuming. This lag may be due to loyalty to
existing consumption bundle, inertia, and delays in information flows.

Posner compares the length of imitation lag and the length of the demand lag. The net lag is 11
month (15 months of imitation lag and 4 months of demand lag). During this 11-month period,
country I will export the product to country II.

Before this period, country II has no real demand for this good and after this period, firms in
country II are also producing and supplying that product, implying that demand for country I’s
product diminishes. Thus, to be a continually exporter, one has to be continually innovating.

4.3.2 The Product Cycle Theory (PCT)

This theory was developed in 1966 by Raymond Vernon. One of the purposes of this theory is to
explain Leontief’s paradox. It builds on the imitation lag hypothesis in its treatment of delay in
the diffusion of technology. This theory is concerned about the life-cycle of a typical ‘new
product’ and its impact on the international trade. Vernon emphasizes manufacturing goods,
and the theory begins with the development of new product in the US. The new product will
have to main characteristics; first, it will cater to high-income demands because US is a high
income country; and second, the product is labor-saving and capital using in production
process (may also be labor saving for consumers – microwave) because US is considered to be a
labor-scarce country.

The PCT divides the life-cycle of this new product into three stages: the new-product stage, the
maturing-product stage and the standardized product stage.

The New-Product Stage:

 A new product is developed in the developed country (DC) – US.


 Firms produce in the US because that is where the demand is located (high income
people).
 Nature of production process and the product itself change its nature because the firms
seek to familiarize with the product and the market – no standardization of product.
 Production is other DCs is nearly zero.
 There may be a few demand in the other DCs, but insignificant.
 No international trade.

The Maturing-Product Stage:

 Some standardization and mass production start taking place.


 Possibility of economies of scale (as opposed to CRS in earlier trade theories)

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 Increase in the demand form other DCs (high income countries) → export from US to
other DCs.
 Firms may begin to explore the possibility of producing in other DCs (cost reduction).
They would do so if the cost of producing at home plus the transportation cost exceeds
the production cost abroad → technology transfer through FDI.
 Export displacement of US produced output occurs. (If an US firm sets up a plant in
France, that facility may be used to export the good not only in France but also
neighboring countries).
 Thus, initial increase in US export is followed by its decline and a likely decline in US
production of that good as well. This relocation of production recognizes the movement
of factors (K and management) internationally (as opposed to earlier trade theories
where factors of production were immobile internationally).
 K being more mobile than L → equalization of price of capital across countries →
difference of product prices comes from the difference in its labor cost → with lower
labor cost in Europe (not true anymore), Europe might undersell US → US may start
importing this good.
 Relative factor endowment and relative factor prices, which played a significant part in
H-O model, have been completely ignored in the PCT.

The Standardized-Product Stage:

 Product is highly standardized.


 Many producers in the world.
 Widespread technology and mass production.
 Increase in the importance of the cost of labor in deciding the competitiveness of the
product.
 Production may shift to developing countries.
 US and the other DCs might import the product from developing countries.

This theory was developed partly to


explain the Leontief paradox: the
US exports the new product (may
be labor intensive) and imports
standardized products (may be
capital-intensive).

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Empirical Verification of the PCT: There is no single all-encompassing test for the PCT.
However, new product development (which is critical to PCT) is often the result of R&D
expenditure. Therefore, there should be positive correlation between R&D expenditure and the
successful export performance. Kravis and Lipsey (1992), found that high R&D intensity was
positively associated with large share of exports by US MNCs. Furthermore, greater shares of
exports from US MNCs have come from overseas production, which is consistent with the
direct investment and export displacement feature of the PCT. Hufbauer (1966) found that the
US and other DCs tended to export new products while the developing countries tended to
export older products. Gruber, Mehta and Vernon (1967) discovered that research-intensive US
industries have high propensity to invest abroad (conformation with maturing-stage of PCT).

In 1979, Vernon suggested to modify his PCT theory to include the possibility of a new product
being developed by other countries because of the presence of subsidiaries of large MNCs in
other countries.

4.3.3 The Linder Theory

This theory was proposed by S. B. Linder in 1961. This theory drastically departs from the H-O
model because it is almost exclusively demand oriented. This theory is for manufactured goods
only.

The Linder theory postulates that per capital income of a country shapes the tastes and hence
the structure of demand in that country which, in turn, will generate a production response by
the firms in that country. Hence, the kind of goods produced in a country reflect the per capital
income level of that country.

 3 countries (I, II and III: I being the poorest and III being the richest).
 9 goods (A-I) ranked in terms of quality or sophistication (A is of the lowest quality).
 Country I demands for A-E, country II for C-G, and country III for E-I.
 Each country will produce only those goods for which demand exists within the
country.

A B C D E F G H I
I x x x X x
II x X x X x
III x X x x x
 x: goods for which there are demand in that country and only these will be produced
under autarky.
 Good C, D and E will be traded between country I and II; good E, F and G will be traded
between country II and III; and good E will be traded between I and III.

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 Implication: international trade in manufactured goods will be more intense between countries
with similar per capita income levels than between countries with dissimilar per capital income
levels.
 Though Linder’s theory identifies which good will be traded and which one will not, it
does not identify the direction of the trade flows.
 Linder, however, said that a good might be sent in both directions – exported and
imported by the same country. As it will be explained later, this kind of trade can
happen if the products are differentiated. For example, in the car market, US exports
Ford to Japan and imports Honda from there. This type of trade is called ‘Intra-Industry
Trade (IIT).

Empirical Verification of the Linder Theory: It can be theoretically hypothesized that as the
difference between per capital income grows, the intensity of trade decreases between any two
countries (negative relationship). Sailors, Qureshi and Cross (1973), found the negative
relationship. But they did not take into account the geographical distance between the countries
(they looked at correlation coefficients mainly). Later more sophisticated tests (based on gravity
model in a multiple regression context), found evidence supporting the Linder’s theory.

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