Heckscher-Ohlin / Factor Proportions Theory Analysis:

A Study Guide

Here is a brief study guide to help you master the Heckscher-Ohlin / Factor Proportions
Theory. There are three elements to this theory – each of which is designed to answer a
different question.

The H-O Theorem aims to answer the question, “Where does comparative advantage
come from and why does it change?” Eli Heckscher and Bertil Ohlin found the answers
to these questions in the differing and changing relative factor proportions of various
nations. Example: Why does the US have a comparative advantage in high tech
industries, and what has enabled Japan to shift its comparative advantage from labor-
intensive textiles (in the years after WWII) to high technology manufacturing products?

The Factor-Price Equalization Theorem answers the question, “How does international
trade affect the differences in relative factor prices between nations?” Example: How
does trade affect the gap between relative labor wages in India and relative labor wages
in the US?

The Stolper-Samuelson Theorem answers the question, “How does trade affect the
distribution of income among factors of production within nations?” Example: Does
trade increase labor’s share of the income or does it shift the distribution towards the
owners of capital?

The Heckscher-Ohlin (H-O) factor proportions theory of international trade is a tight

logical model that must be used carefully and precisely. Here is an example of a correct
use of this analytical framework.

Assume the following stylized facts about Vietnam and the United States and the goods
that they produce.

United States Relative abundant in physical capital (K).

Relatively scarce in Semi-skilled labor
(SSL).

Vietnam Relatively abundant in SSL. Relatively

scarce in K.

Machine Tools and Production intensively uses K.

chemicals.

Textiles and farm Production intensively uses SSL.

goods.
It is, of course, necessary to distinguish among different types of labor in any analysis
involving the United States since the U.S. is neither labor scarce nor labor abundant, but
rather abundant is some particular sorts of labor and scarce in other types of labor.

In autarky, each nation would produce for its own consumption. The abundant factors in
each nation would be relatively cheap (compared to the same factors in the nation where
they are scarce). Hence the products that intensively use the abundant factors would be
relatively cheaper than those same products in the countries where the factors are scarce
(e.g. textiles would be relatively cheaper in Vietnam than in the U.S. in autarky).

H-O suggests that each nation will have a comparative advantage in the good(s) that
intensively use its abundant factor(s). With free trade, each nation will specialize in and
exports its comparative advantage good(s). For example, with its abundant SSL, we
would expect Vietnam to specialize in and export textiles and farm goods because these
products intensively use the relatively cheap factor SSL in their production.

Comparative advantage is therefore determined, in the H-O world, by the interaction of

the factor-abundancies of nations and the factor-intensities of products. It follows that
comparative advantage can change for a nation if either (1) its relative factor abundancy
changes compared to other nations or (2) if technological changes create a change in the
factor-intensity properties of particular products. Japan, for example, went from being a
SSL labor abundant country to a country abundant in capital and skilled labor. Its
comparative advantage changed correspondingly. Technological change can turn labor-
intensive products into capital intensive ones or vice-versa.

The Factor Price Equalization Theory (FPE) explains how the movement from autarky to
free trade will affect relative factor prices in the trading nations. Essentially, FPE argues
that free trade tends to equalize relative factor prices across national borders. Thus, for
example, trade tends to raise the relative price of K in the United States, because K is
intensively used in the expanding K-intensive export industries. The demand for K thus
increases, raising its relative price. At the same time, the relative price of K tends to fall
in Vietnam as trade begins. The autarky price of K was high in Vietnam because it is a K-
scarce country. As trade begins, Vietnam begins to rely less on its own production of K-
intensive goods and instead imports cheaper K-intensive goods from the U.S. As the K-
intensive sector in Vietnam contracts, the relative price of K falls. In theory, this pattern
continues until the relative price of K in the U.S. (that is, the price of K in the U.S.
relative to the prices of other factors in the U.S.) and the relative price of K in Vietnam
have reached equality at some level between the two autarky equilibria. The relative
prices of other factors are similarly equalized across national borders.

Three short notes about FPE. First, in the real world, because of market imperfections,
FRE is a tendency, not an outcome. Second, note that FPE talks only about relative prices
and wages, not absolute prices and wages. So if K earns $20/hr and SSL $10/hr in the US
while K earns $4 and SSL $2 in Vietnam, FPE holds (the relative prices are equal even
though the absolute prices are different). Finally, FPE obviously says that relative factor
prices will tend towards equality between nations, not within nations. It would be foolish
to think that trade will cause the wage of scarce SSL to rise to level of the wage of
abundant K in the US, for example.

The Stolper-Samuelson Theory (S-S) explains how the movement from autarky to free
trade affects the distribution of real income (RGDP) among different factors within
nations. Trade, of course, tends to increase the level of real income in trading nations as
efficient production specialization and mutually advantageous exchange occur. At the
same time, as seen above, the relative factor payments to abundant factors rise. The
expansion of export industries that intensively use the abundant factors bid up their
relative factor prices. The relative factor prices of scarce factors fall for symmetrical
reasons.

As the price of the abundant factor rises, firms attempt to substitute some of the relatively
cheaper scarce factor in the production process (factor substitution). For example, as SSL
gets more expensive in Vietnam, firms will try to substitute capital for some SSL, which
has the effect of raising the productivity of the SSL that gets to use the extra capital. This
acts to increase the productivity of the abundant factor, increasing its real wage as well as
its relative wage. The abundant factor thus experiences both a rise in demand and a rise in
its productivity. No wonder trade benefits the abundant factor of production.

This pattern of changes alters the distribution of real income among factors. Thus we can
say that abundant factors gain unambiguously from trade, as they have a larger share of
the rising real income of the nation. Scarce factors may gain, lose, or experience no
change in real income depending upon whether their falling share of national income is
offset by the increase in real income. If, for example, SSL in the US experiences a 2%
fall in its income share and national income rises by only 1%, then it is worse off. On the
other hand, if K in Vietnam experiences a 5% fall in its income share, but national
income rises by 10%, then it has gained.

Country United States Vietnam

Abundant Factor Capital K Semi-skilled labor SSL

Comparative Advantage (H-O) K-intensive SSL-intensive product

product

Affect of specialization and trade Increases r Increases w relative to r

on factor prices (FPE) relative to w

Factor substitution effects of Increases Increases productivity of

specialization productivity of K SSL

Unambiguous winner (S-S) Owners of K Semi-skilled labor

Applying this analysis to the U.S.-Vietnam case, we can see that U.S. K-owners had a
clear reason to favor a removal of the trade embargo with Vietnam. Trade would expand
production of the K-intensive good, raise the relative wage paid to the owners of K, and
increase the marginal product of K. The impact on SSL in the U.S. requires econometric
analysis to estimate income and share effects. Although SSL would experience falling
relative wages, they could still benefit from the economic growth that trade makes
possible. It appears that SSL would clearly gain in Vietnam while additional study is
required to know how K-owners and SL would fare.

All of this analysis is possible only if we remain tightly within the framework provided
by H-O analysis. If we slip out of this framework and do not, for example, analyze a
consistent set of factors, then the conclusions do not follow.