The Modern Theory of international trade has been advocated by Bertil Ohlin. Ohlin has drawn his ideas from Heckscher’s General Equilibrium Analysis. Hence it is also known as Heckscher Ohlin (HO) Model.
According to Bertil Ohlin, trade arises due to the differences in the relative prices of different goods in different countries. The difference in commodity price is due to the difference in factor prices (i.e. costs). Factor prices differ because endowments (i.e. capital and labour) differ in countries. Hence, trade occurs because different countries have different factor endowments.
The Heckscher Ohlin theorem states that countries which are rich in labour will export labour intensive goods and countries which are rich in capital will export capital intensive goods.
Assumptions of Heckscher Ohlin’s H-O Theory
Heckscher-Ohlin’s theory explains the modern approach to international trade on the basis of following assumptions:
- There are two countries involved.
- Each country has two factors (labour and capital).
- Each country produce two commodities or goods (labour intensive and capital intensive).
- There is perfect competition in both commodity and factor markets.
- All production functions are homogeneous of the first degree i.e. production function is subject to constant returns to scale.
- Factors are freely mobile within a country but immobile between countries.
- Two countries differ in factor supply.
- Each commodity differs in factor intensity.
- The production function remains the same in different countries for the same commodity. For e.g. If commodity A requires more capital in one country then same is the case in other country.
- There is full employment of resources in both countries and demand are identical in both countries.
- Trade is free i.e. there are no trade restrictions in the form of tariffs or non-tariff barriers.
- There are no transportation costs.
Given these assumption, Ohlin’s thesis contends that a country export goods which use relatively a greater proportion of its abundant and cheap factor. While same country import goods whose production requires the intensive use of the nation’s relatively scarce and expensive factor.
Understanding the Concept of Factor Abundance
In the two countries, two commodities & two factor model, implies that the capital rich country will export capital intensive commodity and the labour rich country will export labour intensive commodity. But the concept of country being rich in one factor or other is not very clear. Economists quite often define factor abundance in terms of factor prices. Ohlin himself has followed this approach. Alternatively factor abundance can be defined in physical terms. In this case, physical amounts of capital & Labour are to be compared.
Price Criterion for defining Factor Abundance
A country where capital is relatively cheaper and labour is relatively costly is said to be capital rich country. Whereas a country where labour is relatively cheaper and capital is relatively costly is said to be labour rich country.
Price of the factor can be symbolically measured as follows:
In above relation,
P refers to price of the factor,
K refers to Capital,
L refers to Labour,
E stands for England, and
I stands for India.
Note:- In reality, England is not a country else a part of United Kingdom (U.K). England is called a country in this article just for the sake of learning example.
The above analysis highlights a fact that in England capital is cheap, and hence it is a capital abundant country. Whereas in India, Labour is cheaper, and thus it is a labour rich country.
Now lets understand how such a pattern of trade will necessarily emerge.
Diagram Explaining Heckscher Ohlin’s H-O Theory
Let us take an example of same two countries viz; England and India where England is a capital rich country while India is a labour abundant nation.
In the above diagram XX is the isoquant (equal product curve) for the commodity X produced in England. YY is the isoquant representing commodity Y produced in India. It is very clear that XX is relatively capital intensive while YY is relatively labour incentive. The factor capital is represented on Y-axis while the factor labour is represented on the horizontal X-axis.
PA is the price line or budget line of the country England. The price line PA is tangent to XX at E. The price line PA is also tangent to YY isoquant at K. The point K will help us to find out how much of capital and labour is required to produce one unit of Y in England.
P1B is the price line of the country India, The price line P1B is tangent to YY at I. The price line RS which is drawn parallel to P1B is tangent to XX at M. This will help us to find out how much of capital and labour is required to produce one unit of commodity X in India.
Under the given situations, the country England will choose the combination E. Which means more specialisation on capital goods. It will not choose the combination K because it is more labour intensive and less capital intensive.
Thus according to Ohlin, England will specialise on production of goods X by using the cheap factor capital extensively while India specialises on commodity Y by using the cheap factor labour available in the country.
The Ohlin’s theory concludes that:
- The basis of internal trade is the difference in commodity prices in the two countries.
- Differences in the commodity prices are due to cost differences which are the results of differences in factor endowments in two countries.
- A capital rich country specialises in capital intensive goods & exports them. While a Labour abundant country specialises in labour intensive goods & exports them.
Limitations of Heckscher Ohlin’s H-O Theory
Heckscher Ohlin’s Theory has been criticised on basis of following grounds:
Unrealistic Assumptions: Besides the usual assumptions of two countries, two commodities, no transport cost, etc. Ohlin’s theory also assumes no qualitative difference in factors of production, identical production function, constant return to scale, etc. All these assumptions makes the theory unrealistic one.
Restrictive: Ohlin’s theory is not free from constrains. His theory includes only two commodities, two countries and two factors. Thus it is a restrictive one.
One-Sided Theory: According to Ohlin’s theory, supply plays a significant role than demand in determining factor prices. But if demand forces are more significant, a capital abundant country will export labour intensive good as the price of capital will be high due to high demand for capital.
Static in Nature: Like Ricardian Theory the H-O Model is also static in nature. The theory is based on a given state of economy and with a given production function and does not accept any change.
Wijnholds’s Criticism: According to Wijnholds, it is not the factor prices that determine the costs and commodity prices but it is commodity prices that determine the factor prices.
Consumers’ Demand ignored: Ohlin forgot an important fact that commodity prices are also influenced by the consumers’ demand.
Haberler’s Criticism: According to Haberler, Ohlin’s theory is based on partial equilibrium. It fails to give a complete, comprehensive and general equilibrium analysis.
Leontief Paradox: American economist Dr. Wassily Leontief tested H-O theory under U.S.A conditions. He found out that U.S.A exports labour intensive goods and imports capital intensive goods, but U.S.A being a capital abundant country must export capital intensive goods and import labour intensive goods than to produce them at home. This situation is called Leontief Paradox which negates H-O Theory.
Other Factors Neglected: Factor endowment is not the sole factor influencing commodity price and international trade. The H-O Theory neglects other factors like technology, technique of production, natural factors, different qualities of labour, etc., which can also influence the international trade.