HECKSCHER OHLIN THEORY

The Heckscher-Ohlin Theory of Trade

• The Heckscher-Ohlin theory of trade, (named after two Swedish economists, Eli Heckscher and his student Bertil Ohlin), also referred to as Factor-Endowment Theory of Trade or Modern Theory of Trade, is considered as a very important theory of international trade. In view of the contributions made by P. A. Samuelson, this theory is also sometimes referred to as Heckscher-Ohlin-Samuelson theorem.
• The Heckscher-Ohlin (H-O) model studies the case that two countries have different factor endowments under identical production function and identical preferences. The difference in factor endowment results in two countries having different factor prices in the beginning. Consequently, H-O model implies that the two countries will have different cost functions.
•  The Heckscher-Ohlin theory of trade states that comparative advantage in cost of production is explained exclusively by the differences in factor endowments of the nations. In a general sense of the term, ‘factor endowment’ refers to the overall availability of usable resources including both natural and man-made means of production. Nevertheless, in the exposition of the modern theory, only the two most important factors—labour and capital— are taken into account.
• According to this theory, international trade is but a special case of inter-regional trade. Different regions have different factor endowments, that is, some regions have abundance of labour, but scarcity of capital; whereas other regions have abundance of capital, but scarcity of labour. Different goods have different production functions, that is, factors of production are combined in different proportions to produce different commodities.
•  While some goods are produced by employing a relatively larger proportion of labour and relatively small proportion of capital, other goods are produced by employing a relatively small proportion of labour and relatively large proportion of capital. Thus, each region is suitable for the production of those goods for whose production it has relatively plentiful supply of the requisite factors.
•  A region is not suitable for production of those goods for whose production it has relatively scarce or zero supply of essential factors. Hence different regions have different capacity to produce different commodities. Therefore, difference in factor endowments is the main cause of international trade as well as inter-regional trade.
•  According to Ohlin, the immediate cause of inter-regional trade is that goods can be bought cheaper in terms of money than they can be produced at home and this is the case of international trade as well. The cause of difference in the relative prices of goods is the difference the amount of factor endowments, like capital and labour, between two countries.
•  The theory states that a country’s exports depend on its resources endowment i.e. whether the country is capital-abundant or labour-abundant. If a country is a capital abundant one, it will produce and export capital-intensive goods relatively more cheaply than another country. 
• Likewise, a labour-abundant country will produce and export labour-intensive goods relatively more cheaply than another country. The labour-abundant countries have comparative cost advantage in the production of goods which require labour-intensive technology and by the same reasoning, capital-abundant countries have comparative cost advantage in the production of goods that need capital-intensive technology. 
• The Heckscher-Ohlin theory of foreign trade can be stated in the form of two theorems namely, Heckscher-Ohlin Trade Theorem and Factor-Price Equalization Theorem.The Heckscher-Ohlin Trade Theorem establishes that a country tends to specialize in the export of a commodity whose production requires intensive use of its abundant resources and imports a commodity whose production requires intensive use of its scarce resources.
• The Factor-Price Equalization Theorem states that international trade tends to equalize the factor prices between the trading nations. In the absence of foreign trade, it is quite likely that factor prices are different in different countries. International trade equalizes the absolute and relative returns to homogenous factors of production and their prices. 
• In other words, the wages of homogeneous labour and returns to homogeneous capital will be the same in all those nations which engage in trading. The factor price equalisation theorem says that if the prices of the output of goods are equalised between countries engaged in free trade, then the price of the input factors will also be equalised between countries. 
• This implies that the wages and rents will converge across the countries with free trade, or in other words, trade in goods is a perfect substitute for trade in factors. The Heckscher-Ohlin theorem, thus, postulates that foreign trade eliminates the factor price differentials. The factor price equalization theorem is in fact a corollary to the Heckscher-Ohlin trade theory. It holds only so long as Heckcher-Ohlin Theorem holds. 
• The basic assumption of the Heckscher-Ohlin theorem is that the two countries share the same production technology and that markets are perfectly competitive. The opening up to trade for a labour-abundant country will increase the price of labour-intensive goods, say clothes, and, thus, lead to an expansion of clothes production.
•  As there is demand for exports of clothes in foreign markets, the demand for factors of production increases in the clothes sector. Because clothes are labour-intensive goods, an increasing demand for labour in the factor market will attract labour from the capital-intensive industry, say machine tools. The expanding clothes industry absorbs relatively more labour than the amount released by the contracting machine tools industry. The price of labour goes up, and whilst its relative price increases, the relative price of capital declines. 
• As a result, the factors of production will become more capital-intensive in both sectors leading to a decline in the marginal productivity of capital and an increase in that of labour in both sectors. Similarly, when country B increases its specialization in the production of capital-intensive commodity its demand for capital increases causing capital returns to increase in relation to wage rate. This means that specialization leads to change in relative factor prices.
• When the prices of the output of goods are equalized between countries as they move to free trade, then the prices of the factors (capital and labor) will also be equalized between countries. It means that product mobility and factor mobility become perfect substitutes. Whichever factor receives the lowest price before two countries integrate economically and effectively become one market will therefore tend to become more expensive relative to other factors in the economy, while those with the highest price will tend to become cheaper.

The table 4.1.3 presents, though not exhaustive, a comparison of the theory of comparative costs and modern theory.
                                                          Table 4.1.3

                            Comparison of Theory of Comparative Costs and Modern Theory 

Theory of Comparative Costs	Modern Theory
The basis is the difference between countries is comparative costs	Explains the causes of differences in comparative costs as differences in factor endowments
Based on labour theory of value	Based on money cost which is more realistic.
Considered labour as the sole factor of production and presents a one-factor (labour) model	Widened the scope to include labour and capital as important factors of production. This is 2-factor model and cand be extended to more factors.
Treats    international   trade   as    quite distinct from domestic trade	International trade is only a special case of inter-regional trade.
Studies only comparative costs of the goods concerned	Considers the relative prices of the factors which influence the comparative costs of the goods
Attributes the differences in comparative advantage to  differences in productive efficiency of workers	Attributes the differences in comparative advantage to the differences in factor endowments.

Does not take into account the factor price differences	Considers factor price differences as the main cause of commodity price differences
Does    not    provide    the    cause             of differences in comparative advantage.	Explains the differences in comparative advantage in terms of differences in factor endowments.
Normative; tries to demonstrate the gains from international trade	Positive; concentrates on the basis of trade