The Heckscher Ohilin Theory

Introduction
 The classical comparative cost theory did not satisfactorily
explain why comparative costs of producing various
commodities differ as between different countries.

 The theory explained that it is differences in factor

endowments of different countries and different
factor-proportions needed for producing different
commodities that account for difference in comparative
costs.

 This new theory is therefore-called Heckscher-Ohlin

theory of international trade.
• Therefore this theory explains the reason for the
difference in relative commodity prices and
comparative advantage between the two nations.

• Thus this trade model examines the basis for

comparative advantage and the effect that trade
has on factor earnings in the two nations.
 Assumption of Heckscher Ohilin Theory
• There are two nations (Nation 1 and Nation 2), two
commodities (commodity X and commodity y), and two
factors of production (labour and capital)

• Commodity X is labour intensive and commodity Y is capital

intensive in both nations.

• Constant returns to scale in the production of both

commodities in both nations.

• Incomplete specialization in production in both nations

• Equal tastes in both nations

 Assumption of Heckscher Ohilin Theory
• Perfect competition in both commodities and factor markets
in both nations

• Perfect factor mobility with in each nation but no international

factor mobility

• No transportation costs, tariff, or other obstructions to the

free flow of international trade.
 Factor Intensity
If the capital – labour ratio (K/L) used in the production of one
commodity (Y) is greater than K/L used in the production of
another commodity(X), we can say Y is capital intensive and X is
labour intensive.
Factor Abundance
There are two ways to define factor abundance.
• In terms of physical units
• In terms of relative factor prices

The definition of factors abundance in terms of relative factor

prices considers both demand and supply.
 Labour Abundant Nation
The nation with the higher ratio of total labour to total capital
(L/K) and lower ratio of wages to interest (w/r) is known as L –
Abundant nation.
Capital Abundant Nation
The nation with the higher ratio of total capital to total labour
(K/L) and lower ratio of interest to wages (r/w) is known as K –
Abundant nation.

The Heckscher Ohilin Theory

1. H – O Theorem – deals with pattern of trade
2. Factor – Price Equalization Theorem – deals with effect of
international trade on factor prices
 H – O Theorem
• H – O theorem explains comparative advantage rather
than assuming it.

H – O Theorem can be explained as follows;

• A nation will export the commodity whose production
requires the intensive use of the nation’s relatively abundant
and cheap factor and import the commodity whose
production requires the intensive use of the nation’s relatively
scare and expensive factor.
 H – O Theorem

• That is relatively labour – rich nation exports the relatively

labour – intensive commodity and imports the relatively
capital – intensive commodity.

• According to the theory, the difference in relative factor

abundance and prices is the cause of the pre trade
difference in relative commodity prices between two nations
and immediate cause for the trade.
 Factor – Price Equalization Theorem

• International trade will bring equalization in the relative

and absolute returns to homogeneous factors between the
trading nations.

• International trade will cause wages of

the
homogeneous labour to be the same in all trading
nations and the return to homogeneous capital to be
the same in all trading nations.

• That is, w will be the same in all trading nation and r will
be the same in all trading nation as well.
 Factor – Price Equalization Theorem

• Thus international trade reduces the pre trade differences in w

and r between the two nations. This proves that international
trade will bring complete equalization of relative factor prices.

• International trade also brings equalization of absolute factor

price. This means that free international trade equalizes the
real wages for the same type of labour in the two nations and
real rate of interest in the same type of capital in the two
nations.

• Therefore international trade acts as a substitute for the

international mobility of factors of production in its effect on
factor prices.
Traded commodities or products are essentially comprised of
four kinds of factors, including the following:

Natural Resources: Land, oil, natural gas, minerals, forest

products, animal products and agricultural products, such as
sugar and coffee

Labor: Workers in labor intensive production, such as textiles,

footwear and handbags, furniture

Physical Capital: Machines, buildings, office & data processing,

infrastructure, such as power generating and telecommunications

Human Capital: Education, other skills that enhance

productivity
 Leontief Paradox
• In the early 1950s, Russian-born American economist Wassily
W. Leontief studied the US economy closely and noted that
the United States was abundant in capital and, therefore,
should export more capital-intensive goods.

• However, his research using actual data showed the opposite:

the United States was importing more capital-intensive
goods. According to the factor proportions theory, the United
States should have been importing labor-intensive goods, but
instead it was actually exporting them.

• His analysis became known as the Leontief Paradox because it

was the reverse of what was expected by the factor
proportions theory.
 Leontief Paradox
• In subsequent years, economists have noted historically at that
point in time, labor in the United States was both available
in steady supply and more productive than in many other
countries; hence it made sense to export labor-intensive
goods.
• Over the decades, many economists have used theories and
data to explain and minimize the impact of the paradox.
• However, what remains clear is that international trade is
complex and is impacted by numerous and often-
changing factors.
• Trade cannot be explained neatly by one single theory, and
more importantly, our understanding of international trade
theories continues to evolve.