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Heckscher-Ohlin and Other Trade Theories Course facilitator: Rajesh KP

Factor Endowments and Heckscher-Ohlin Theory The classical comparative cost theory maintained that the comparative cost advantage of trading nations was based on differences in labor productivity, but they failed to provide satisfactory explanation for such differences. The theory for analyzing the pattern of international trade developed by Swedish economists Eli Heckscher (1919) and Bertil Ohlin (1933) attempted to deal with this question. This theory did not supplant the comparative cost theory but supported it by providing explanation for the relative commodity price differences between the countries and their respective comparative advantages.

Factor Endowments and Heckscher-Ohlin Theory Heckscher-Ohlin Theory addressed two questions left largely unexplained by Ricardo: What determines comparative advantage? What effect does international trade have on the earnings of various factors of production in trading nations? Because Heckcher Ohlin maintained that factor (resource) endowments underlie a nation’s comparative advantage, their theory become known as the Factor Endowment Theory . It is also known as Heckscher-Ohlin Theory .

Heckscher-Ohlin Theory The Heckscher-Ohlin theory focuses on the differences in the relative abundance of factors of production in various nations as the most important determinant of the difference in relative commodity prices and comaratuive advantage. The Heckscher-Ohlin theory can be expressed in the form of two theorems: the so-called Heckscher-Ohlin theorem and the factor price equalization theorem .

Assumptions of the Theory There are two nations (Nation 1 And Nation 2), two commodities (commodity X and commodity Y), and two factors of production (labor and capital). Both the nations use the same technology in production. Commodity X is labor intensive, and commodity Y is capital intensive in both nations. Both commodities are produced under constant returns to scale in both nations. There is incomplete specialization in production in both nations. Tastes are equal in both nations.

Assumptions of the Theory There is perfect competition in both commodities and factor markets in both nations. There is perfect mobility within each nation but no international factor mobility. There are no transportation costs, tariffs, or other obstructions to the free flow of international trade. All resources are fully employed in both nations. International trade between the two nations is balanced.

Heckscher-Ohlin Theory Heckscher –Ohlin Theory is based on factor intensity and factor abundance. Factor Intensity In a world of two commodities (X and Y) and two factors (labor and capital), we say that commodity Y is capital intensive if the capital-labor ratio (K/L) used in the production of Y is greater than K/L used in the production of X.

Heckscher-Ohlin Theory Factor Abundance There are two ways to define factor abundance. One way is in terms of physical units. Another way is in terms of relative factor prices. According to the definition in terms of physical units, Nation 2 is capital abundant if the ratio of the total amount of capital to the total amount of labour (TK/TL) available in nation 2 is greater than that in Nation 1. According to the definition in terms of factor prices, Nation 2 is capital abundant if the ratio of the rental price of capital to the price of labour (P K /P L ) is lower in Nation 2 than in Nation 1.

Heckscher-Ohlin Theory Heckscher-Ohlin Theorem : A nation will export the commodity whose production requires the intensive use of the nation’s relatively abundant and cheap factor and import commodity whose production requires the intensive use of the nation’s relatively scarce and expensive factor. In short, the relatively labor-rich nations exports the relatively labor-intensive commodity and imports the relatively capital intensive commodity.

Heckscher-Ohlin Theory Thus, the H-O theorem postulates that the differences in relative factor abundance and relative factor prices is the cause of the pre trade commodity prices between two nations. This difference in the relative factor and relative commodity prices is then translated into difference in absolute factor and commodity prices between two nations. It is this difference in absolute commodity prices in two nations that is the immediate cause of trade.

The Formal Heckscher-Ohlin Mdel Autarky equilibrium

The Formal Heckscher-Ohlin Mdel Post-trade equilibrium

Factor Price Equalization and Income Distribution The factor-price equalizations theorem is a corollary to the H-O theorem. It was Paul Samuelson who rigorously proved the factor-price equalizations theorem. Factor-Price Equalizations Theorem: International trade will bring about equalization in the relative and absolute returns to homogeneous factors across nations. It implies that international trade is a substitute for the international mobility of factors.

Factor Price Equalization and Income Distribution Factor-Price Equalizations Theorem: This means that international trade will cause the wages of the same type of labor to be same in all trading nations. Similarly, international trade will cause the return or earnings of homogeneous capital to be the same in all trading nations.

Factor Price Equalization and Income Distribution Suppose in the absence of trade the relative price of commodity X is lower in Nation 1 than Nation 2 because the relative price of labour, or wage rate is lower in Nation 1. As nation 1 specializes in the production of X (the labour intensive commodity) and reduces its production of commodity Y (the capital intensive commodity), the relative demand for labor rises, causing wages to rise, while relative demand for capital falls, causing price of capital or interest rate to fall. The exact opposite occurs in nation 2. Thus, international trade causes wage rate to rise in Nation 1 and to fall in Nation 2 and reduces the pre-trade difference in wages between the two nations.

Factor Price Equalization and Income Distribution Similarly, international trade causes interest rate to fall in Nation 1 and to rise in Nation 2, thus reducing pre-trade differences in interest rates between the two nations.

Factor Price Equalization and Income Distribution Stolper-Samuelson Theorem (effect): It postulates that free international trade reduces the real income of the nation’s relatively scarce factor and increases the real income of the nation’s relatively abundant factor.

Empirical Tests of the Heckscher-Ohlin Theory The first empirical test of the Heckscher-Ohlin model was conducted by W. W. Leontief in 1953 using U.S. data for the year 1947. It has been widely recognized that in the United States capital was relatively abundant and labour was relatively scarce. According to the Heckscher –Ohlin theory, the United State should export capital-intensive goods and its import-competing goods should be labour intensive .

Empirical Tests of the Heckscher-Ohlin Theory In a 1953 article by Leontief showed, using input-output analysis, that U.S. exports were relatively labor-intensive compared to U.S. imports. This was the opposite of what the H-O model predicted, given the high level of U.S. wages and the relatively high amount of capital per worker in the United States. Leontief’s discovery was termed the Leontief Paradox .

Leontief’s First Test One million dollars' worth of typical exportable and importable in 1947 (K/L) x = K x / L x = $14,300 (K/L) m = K m / L m = $18,200 The US is believed to be endowed with more capital per worker than any other country in the world in 1947. Thus, the H-O theory predicts that the US exports would have required more capital per worker than US imports. However, Leontief was surprised to discover that US imports were 30% more capital-intensive than US exports, (K/L) m = 1.30 (K/L) x . (See: W. Leontief, Domestic Production and Foreign Trade: The American Capital Position Re-examined, Proceedings of the American Philosophical Society 97, September 1953.) Capital Requirement Labor Requirement Exports K x = 2550780 L x =182.313 man-years Imports K m = 3091339 L m =170.114 man-years

Leontief’s Second Test One million dollars' worth of typical exportable and importable in 1951 (K/L) x = K x / L x = $12,970 (K/L) m = K m / L m = $13,711 (K/L) m = 1.057 (K/L) x In 1956 Leontief repeated the test for US imports and exports which prevailed in 1951. In his second study, Leontief aggregated industries into 192 industries. He found that US imports were still more capital-intensive than US exports. US imports were 5.7% more capital-intensive. The degree had been reduced but the paradoxical conclusion remained. (See: W. Leontief, Factor Proportions and the Structure of American Trade: Further theoretical and empirical analysis, Review of Economics and Statistics 38, no. 4 November 1956.) Capital Requirement Labor Requirement Exports K x = 2256800 L x =174 man-years Imports K m = 2303400 L m =168 man-years

Empirical Tests of the Heckscher-Ohlin Theory Explanations of Leontief Paradox Explanations of Leontief Paradox Leontief used a two factor model (K and L), thus abstracting from other factors such as natural resources. Leontief included only the physical capital and completely ignored human capital . Recent research using data on many sectors, for many countries, over many years, provided strong confirmation of H-O model.

ECONOMIES OF SCALE AND INTERNATIONAL TRADE

Economies of Scale and International Trade The Ricardian model and the Heckscher-Ohlin model both assume constant returns to scale : If all factors of production are doubled then output will also double. But a firm or industry may have increasing returns to scale or economies of scale . Increasing retunes to scale refer to the production situation where output grows proportionately more than the increase in inputs. If all factors of production are doubled, then output will more than double. Larger is more efficient: the cost per unit of output falls as a firm or industry increases output. Increasing retunes to scale may occur because at a large scale of operation a greater division of labor and specialization becomes possible.

Economies of Scale and International Trade Economies of scale provide incentives for specialization, since per unit costs go down as production increases Trade provides a larger potential market for products, making higher production levels possible

Economies of scale as basis for trade Economies of Scale as a Basis for Trade 0 Average Cost Number of Cars AC A AC 0 50,000 AC 1 B 200,000 C 250,000

Trade Based on Economies of Scale If two nations are assumed to be identical in every respect, we can use a single production frontier and a single indifference map to refer both nations. Increasing retunes to scale result in production frontiers that are convex. As each nation specializes in the production of a commodity, the relative price of the commodity diminishes. With identical production frontiers and indifference maps, the no trade equilibrium relative commodity prices in two nations are also identical.

Trade Based on Economies of Scale With trade, Nation 1 would specialize in the production of commodity X and produce at point B. Nation 2 specialize in the production of Y and produce at point B’. By then 60X for 60Y with each other, each nation would end up consuming at point E on indifference curve II, thus gaining 20 X and 20Y. These gains from trade arise from economies of scale in the production of only one commodity in each nation.

Trade Based on Economies of Scale II I A E B B’

IMPERFECT COMPETITON AND INTERNATIONAL TRADE

Trade Based on Product Differentiation A large portion of output of modern economies today is differentiated rather than homogeneous products. As a result, a great deal of international trade can and does involve the exchange of differentiated products of the same industry. That is, a great deal of international trade is intra-industry trade in differentiated products as opposed to inter-industry trade in completely different products.

Intra-industry Trade Intra-industry trade occurs when a country exports and imports goods within the same industry or product group such as exporting autos and importing autos. In contrast, inter-industry trade occurs when a country exports and imports goods produced in quite different industries such as exporting machines and importing textiles.

Intraindustry Versus Interindustry Trade The Factor-proportions theory does not explain intra-industry trade. Why? Intra-industry trade suggests that a country has a comparative advantage and disadvantage in the same product (since it both exports and imports the product).

Measuring Intra-industry Intraindustry trade is difficult to measure. Why? The broader the industrial classification, the more likely is intra-industry trade. The level of intra-industry trade can be measured by the intra-industry trade index .

Intra-industry trade index Where X = value of exports M = value of imports

Example US imports $150,000 of cloth and exports no cloth Intraindustry Versus Interindustry Trade IIT Index = 0 indicates no intraindustry trade in cloth.

US imports $150,000 of computers and exports $150,000 computers . Intraindustry Versus Interindustry Trade IIT = 1 indicates that all trade in computers is intraindustry trade or alternatively exports of computers = imports of computers.

IIT ranges from 0 (no intraindustry trade) to 1 (100 percent intraindustry trade). The closer to 0, the less intraindustry trade relative to interindustry trade. The closer to 1, the more intraindustry trade relative to interindustry trade. Intraindustry Versus Interindustry Trade

IIT continued Problems Values of intra-industry trade depend on how narrowly a particular industry or product group is defined. More broadly defined groups will show more intraindustry trade, e.g., Motor vehicles More narrowly defined groups will show less intraindustry trade, eg., pickup trucks

The Increasing Importance on Intraindustry Trade

The Increasing Importance on Intraindustry Trade Given problems of measuring intra-industry trade, a best guess is that it now accounts for about 50% of US trade Versus perhaps 25% in 1970

Types of Intraindustry Trade Types of Intraindustry Trade and Associated Processes Same Price Identical Products (Wheat, Concrete, Petroleum) Similar Prices Slightly Different Product Characteristics (Gasoline, Chocolate, Perfume) Varying Prices Widely Different Product Characteristics (Automobiles, Watches) Associated Processes Associated Processes Intraindustry Trade Homogeneous Products Horizontally Differentiated Products Vertically Differentiated Products Reduction of Transportation Costs Provision of Homogeneous Services (Insurance, Shipping, Financing Associated with International Trade) Provision of Uninterrupted Flow of Seasonal Products (Tomatoes) Economies of Scale Product Cycle Overlapping Demands

TECHNOLOGY GAP AND PRODUCT CYCLE MODELS

Technology Gap and Product Cycle Models Apart from differences in the relative availability of labor, capital, and natural resources (stressed by H-O theory) and existence of economies of scale and product differentiation, dynamic changes in technology among nations can be a separate determinant of international trade. These are examined by technology gap and product cycle models.

Technology Gap and Product Cycle Models According to the technology gap model sketched by M.V.Posner in 1961, a great deal of the trade among industrialized countries is based on the introduction of new products and new production processes. This give the innovating firm and the nation a temporary monopoly in the world market. Such a temporary monopoly is often based on patents, copy rights, which are granted to stimulate the flow of inventions.

Technology Gap and Product Cycle Models As the most technology advanced nation, the United States exports a large number of new high technology products. However, as foreign producers acquire the new technology, they eventually are able to conquer markets abroad, and even the U.S. market for the product, because of their lower labor costs. In the mean time U.S. producers may have introduced still newer products and production processes and may be able to export these products based on the new technology gap established. A shortcoming of this model is that it does not explain the size of technology gaps and does not explore the reason that technology gaps arise or exactly how they are eliminated overtime.

Product Cycle A generalization and extension of the technology gap model is the product cycle model , which was fully developed by Raymond Vernon in 1966. According to this model, when a new product is introduced, it usually require highly skilled labor to produce. As the product matures and acquires mass acceptance, it becomes standardized; it can then be produced by mass production techniques and less skilled labor. Therefore, comparative advantage in the product shifts from the advanced nation to less advanced nations, where labor is relatively cheaper. This may be accompanied by foreign direct investments from innovating nation to nations with cheaper labor.

Product Cycle Model There often is a cycle in product development and production. According to the product cycle model a product goes through five stages: The introduction of the product (New product phase), Expansion of production for exports (product growth phase), Standardization and beginning of production abroad through imitation (Product maturity phase), Foreign imitators underselling the nation in third markets, and Foreigners underselling the innovating firms in their home market as well. (Stage I and V are known as product decline stage)

Product Life Cycle Model of International Trade – Innovating country

Product Life Cycle Model of International Trade – Imitating Country

Theory of National Competitive Advantage Harvard Business School Professor Michael Porter’s theory of national competitive advantage is the newest addition to international trade theory. Porter’s 1990 study attempts to analyze the reasons for a nations success in a particular industry.Porter studied 100 industries in 10 nations postulated determinants of competitive advantage of a nation were based on four major attributes Factor endowments Demand conditions Related and supporting industries Firm strategy, structure and rivalry

Porter’s Diamond Success occurs where these attributes exist. More/greater the attribute, the higher chance of success The diamond is mutually reinforcing

Factor endowments Factor endowments:- A nation’s position in factors of production such as skilled labor or infrastructure necessary to compete in a given industry Basic factor endowments Advanced factor endowments

Basic factor endowments Basic factors: Factors present in a country Natural resources Climate Geographic location Demographics While basic factors can provide an initial advantage they must be supported by advanced factors to maintain success

Advanced factor endowments Advanced factors: Are the result of investment by people, companies, government and are more likely to lead to competitive advantage If a country has no basic factors, it must invest in advanced factors

Advanced factor endowments communications skilled labor research Technology education

Demand conditions The nature of home demand for the industry’s product or service influences the development of capabilities Sophisticated and demanding customers pressure firms to be competitive Demand impacts quality and innovation

Related and supporting industries The presence supplier industries and related industries that are internationally competitive can spill over and contribute to other industries Successful industries tend to be grouped in clusters in countries - having world class manufacturers of semi-conductor processing equipment can lead to (and be a result of having) a competitive semi-conductor industry

Firm Strategy, Structure and Rivalry Long term corporate vision is a determinant of success Management ‘ideology’ and structure of the firm can either help or hurt you Presence of domestic rivalry improves a company’s competitiveness

Determinants of Competitive Advantage in nations Government Company Strategy, Structure, and Rivalry Demand Conditions Related and Supporting Industries Factor Conditions Chance Two external factors that influence the four determinants.

Porter’s Theory-predictions Porter’s theory should predict the pattern of international trade that we observe in the real world Countries should be exporting products from those industries where all four components of the diamond are favorable, while importing in those areas where the components are not favorable

Implications for business Location implications : Disperse production activities to countries where they can be performed most efficiently First-mover implications: Invest substantial financial resources in building a first-mover, or early-mover advantage Policy implications: Promoting free trade is in the best interests of the home-country, not always in the best interests of the firm, even though, many firms promote open markets

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