Heckscher Ohlin Theory (Factor Endowment theory)

From this article, you will learn about the fundamentals of the Heckscher ohlin theory, which also knows as factor endowment theory. It includes new HO theorems such as,

• Rybczynski Theorem
• Factor price equalization theory and
• Stolper Samuelsson theory

At the end of the article, you will be able to explain what is the basis of HO theory, and how it distinguishes from the classical theory of international trade, the equilibrium of the HO model.

Introduction to Heckscher ohlin theory

Eli Heckscher (1919) and Bertil Ohlin (1933) developed the theory. The purpose of developing this theory was in order to avoid rigidities and some constraints of the classical model of international trade. Basically, it addresses two questions left by classical theory. It includes,

1. What determine comparative advantage
2. What effects does international trade on the earnings of various factors of production (income distribution)?

Heckscher ohlin theory is based on two countries, two goods, and two factors model which known as the 2x2x2 model.

According to H.O theory, international trade will determine the factor endowment based on resource abundance and factor intensity. Thus a country, which has the abundant resource and factor endowment for capital or labor, it will have factor intensity for making goods from respective factor and it will get the comparative advantage for exporting the goods through specialization.

In contrary, the country will not get the comparative advantage for the scared factor which doesn’t have the factor intensity and it is worth importing the respective goods because the factor intensity is low and no comparative advantage for making it.

What is factor intensity?

The factor intensity refers to factor ratio used in the production of goods. It measures in terms of capital-labour ratio (K/L) or labour-capital ratio (L/K) used for product (Y).

According to the two countries and two factors model, table 1 shows how to determine the factor intensity of labor and capital in the production of X and Y commodities in country A.

The factor intensity refers to factor ratio used in the production of goods. It measures in terms of capital-labour ratio (K/L) or labour-capital ratio (L/K) used for product (Y).

According to the two countries and two factors model, table 1 shows how to determine the factor intensity of labor and capital in the production of X and Y commodities in country A.

Heckscher ohlin theory: Table 1

According to table 1,

Commodity Y is relatively capital abundant compared to commodity (X). Because the capital-labor ratio (K/L) is significantly high for making commodity Y than the commodity X.

Similarly, if measuring the labor-capital ratio (L/K), It is high for X (3/1= 3) than the production of Y (2/3). So X is labor-intensive compared to the Y.

Thus, country A will have a comparative advantage in the production of capital intensive goods and exports to another country. Since country A doesn’t have factor intensity for making X, it is worth importing it instead of producing it at a higher price.

Figure 1: Factor Intensity for Commodities X and Y

Similarly, the factor intensity of Country B is illustrated in fig 5.2. It indicates the labor-capital ratio (L/K ratio) for commodity X is relatively higher than the commodity Y.

So country B could specialize its abundant factor and export labor-intensive products and worthwhile to import capital intensive products made from scared factor.

Heckscher ohlin theory: Table 2

Figure 2: Factor Intensity for Commodities X and Y

In both graphs, Y=10 and X=10 curves represent isoquant of commodity X and Y. FP line in both graphs shows factor price ratios for two goods. Thus Ey and Ex indicate the most efficient points of producing y and X units respectively.

Factor Endowment

According theory there are two criterion for judging factor endowment of a country.

1. Aggregate Factor Ratio
2. Factor – price Ratio

Aggregate Factor Ratio

K A/LA > K B/L B

Where K and L represent the supply of Capital and labor and A and B stand for country A and country B.

Factor – price Ratio

PK A/PL A< PK B/PL B

Where PL = wage rate (w) and Pk = Capital rental (r)

Figure 3: Factor Abundance and the Shape of Production Frontier

Fig. 3 shows that country A is K abundant and commodity X is K intensive good. Thus country A could produce more K intensive goods than country B.

Similarly, country B is a labor abundant nation, and it L intensive Y goods. It could produce more labor-intensive goods than country A.

Thus production frontiers of country A has bowed towards the X-axis and the PPF of country B has bowed towards the Y-axis.

Compared to Classical thoughts of absolute and comparative advantage theories, the HO model is recognized as a complete model as it engages in international trade.

Assumptions of Heckscher ohlin theory

The HO model is also based on the basic assumptions of the classical model except two assumptions related with labor is the only relevant factor and technology depend on the unit of labor. In addition, it adds five more assumptions.

1. There are two factors of production i.e. labor and capital. The capital is paid by rental and labor is paid by wages.
2. The technology available in each countries are identical.
3. The factor endowments of the country vary from the other nation.
4. Factor intensity varies between goods. For instance, some goods are capital intensive and some are labor-intensive products.
5. Countries have the same taste and preferences.
6. The country will have a comparative advantage and export the goods which is abundant in production factors and have a relative intensity.

Illustration of the H. O. theory And Equilibrium

According to the basic assumption of the H.O. model resource-abundant country can get the factor intensity and it will get the comparative advantage of the respective products.

As a very comprehensive theory, it assumed two factors of production instead of labor is the only factor of production as assumed in classical theory. Thus two countries, two goods model is improved as two countries, two goods, and the two-factor model.

So if assumed that Country A as the capital-abundant country it has the capital intensity and country B as the land abundant country, it has land-intensity in production.

So if both countries specialize their abundant factors which have comparative advantage for production, production possibility frontiers and domestic price lines are determined accordingly as the factor endowment and intensity.

According to figure 4 (a), it shows autarky equilibrium without no trade. Country A is a capital-intensive country and it produces autos and country B produces wheat as labor-intensive products.

tt lines represent domestic factor prices of two countries while the CIC 0 represents the consumer preferences of two nations.
Once trade allowed between two countries the country A will specialize its abundant factor (capital) and produce more autos for the foreign markets.

Similarly, country B will also use its abundant factor (labor) and produce more wheat for the foreign market. Both countries sell their products at TOT price which determined reciprocally between the two nations. Both countries will import products based on scared factor. The Post-trade equalization is shown in fig. 4 (b).

Figure 4: Equilibrium in the HO Model

Conclusion

The theory could summarize as follows.

1) The model shows that comparative advantage is determined by the relative abundance of factors of production and therefore the relative price levels differ among the nation.

2) Unlike the classical version, the HO version predicts that during the equilibrium of every united state of America will retain to provide a number of each good.

3) Unlike different models, the HO version calls for that strict assumptions be made on the character of the flavor of every country.

4) The HO model is extremely useful for analyzing the effects of trade on income distribution.