H.

P NATIONAL LAW UNIVERSITY,

SHIMLA
ASSINGMENT
OF
ECONOMICS
(HECKSCHER – OHLIN THEORY OF TRADE – ITS MAIN FEATURES,
ASSUMPTIONS AND LIMITATIONS)

SUBMITTED TO:
SIR HARI CHAND THAKUR
SUBMITTED BY:
NAVISHA VERMA
B.A.LLB(HONS.)
3rd SEMESTER
ROLL NUMBER: 1020181960
Academic Year 2018-2019

ACKNOWLEDGMENT
Every project big or small is successful largely due to the effort of many people who have

always helped from behind for every successful work. This project has been completed not

only by my efforts but several others who have timely helped me at every step I moved

forward. I would like to thank my module tutor Dr. Ved Prakash for giving this opportunity

to work on such an enlightening topic. I would also like to thank my family and friends for

providing me with full support, help and motivation at the time when I needed it the most.

I Navisha Verma, the student of H.P. NATIONAL LAW UNIVERSITY (SHIMLA), am

extremely grateful to H.P. NATIONAL LAW UNIVERSITY (SHIMLA), for the
confidence bestowed in me and entrusting me of management principles.

I would also like to thank all the faculty members of H.P. NATIONAL LAW
UNIVERSITY (SHIMLA), for their critical advice and guidance without which this project
would not have been possible.

DATE –9th October 2019. Name – Navisha Verma

Contents
INTRODUCTION......................................................................................................................4
ASSUMPTIONS OF THE HECKSHER-OHLIN THEORY....................................................5
CRITICISM................................................................................................................................9

INTRODUCTION
The structure of the modern theory of international trade rests fundamentally upon the theory
developed by Eli Heckscher and Berlin Ohlin. This theory has almost completely replaced the
classical and non-classical theories related to international trade. But it does not mean that
there is some real conflict between the Hecksher-Ohlin approach and the comparative costs
approach or that the former in any way, invalidates the latter. In fact, the Hecksher-Ohlin
approach in a powerful manner. it goes behind the comparative costs doctrine to investigate
the basic the cause of the relative differences in costs. Hecksher and Ohlin have traced the
cause of cost differences to relative factor endowments and relative factor intensities. That is
why theory is also known as Proportions-Factor-Intensity Theory. According to this theory,
countries which are rich in labour-intensive goods and those rich in capital will export
capital-intensive goods.

ASSUMPTIONS OF THE HECKSHER-OHLIN THEORY

The H.O. theory is based upon the following assumptions:

1. This theory considers a two-country, two-commodity and two factor (labour and
capital) case. It is possible, however, to extend the theory to a multi-factor and multi-
commodity case. But such an extension can be done only if the number of factors and
number of commodities are equal.
2. The factors of production are perfectly mobile within their respective countries, but
they are immobile between the countries.
3. There is a state of perfect competition both in the product and factor markets.
4. There is full employment of the factors of production in both the countries.
5. Production functions pertaining to both the commodities are linearly homogenous. It
implies that the production is governed by constant returns to scale.
6. The techniques of production in both the countries remain unchanged. In such a
situation, the input-output in production functions will remain unchanged.
7. The consumer’s taste pattern and therefore the demand function for different goods
are identical in both the countries.
8. The factors endowments, in absolute terms, remain constant in both the countries but
the relative endowments of the two factors are disproportionate in the two countries.
9. The production functions are such that the two commodities show different factor
intensities-one commodity is capital-intensive and the other is labour-intensive.
Although production functions for different commodities are different, yet the
production functions for each commodity are the same in both the countries.
10. The factor intensities are not reversible.
11. The trade between the two countries is free and unrestricted.
12. There is an absence of transport costs so that product prices are related exclusively to
factor costs.
 13. There is incomplete specialisation in the trading countries.
As mentioned above the whole basis of differences in comparative costs according to H-O
theory, rests upon two crucial elements-factor endowments and factor intensities.

FACTOR ENDOWMENTS
It is incontrovertible fact that regions or countries differ from one another in respect of
endowments or availability of factors. In country A, there may be an abundance of capital
and labour may be scarce. On the opposite, there may be an abundance of labour in country
B, while capital may be scarce. The terms ‘relative factor abundance’ in H-O model can be
defined in terms of two criteria-
1) The physical criterion of relative factor abundance.
According to this criterion, a country is said to be relatively capital abundant, if and only if, it
is endowed with a higher proportion of capital to labour than the other country. The country
A can be called as relatively capital abundant, if the following condition is satisfied:

where K and L refer to capital and Labour respectively. Bars over K and L signify the fixed
factor quantities in each country. The subscripts A and B refer to countries A and B.
Similarly the realtive scarcity of labour, in physical terms, in country A can be expressed as

For country B, relative labour-abundance can be indicated by-

and capital-scarcity in this country can be denoted by

Given the above conditions, H-O theory lays down that country A will produce capital-
intensive cpmmodity (say machine) and country B will have a bias in producing labour-
intensive commodity (say,cloth). If both the countries produce machine and cloth in the same
proportion and production occurs along OR in Fig. 1 ,the country A would be
 Fig. 1
producing at C and country B at D. The points C and D lie on the respective production
possibilty curves PQ and P1Q1 of these two countries. Since at point C, the slope of country
A’s production possibility curve is more steep more than the slope of the production
possibility possibility curve of country B and D, this will imply that MC of producing cloth in
country A is higher than MC of producing cloth in country B. So if the production takes place
point C and D, machines can be produced more cheaply in country B. Since country A is
capital-abundant and the production of machines is capital-intensive, country A will tend to
extend the production of machines. Country B, at the same time being labour-abundant will
tend to extend the production of cloth, which is realtively labour-intensive.
The Hecksher-Ohlin theorem can, however, be valid on the basis of this physical criterion
and give the above conclusion only if the consumption pattern in both the countries is
identical and the income elasticity of demand for each commodity equals unity. If the
demand conditions are different in two countries, the conclusion that capital-intensive
commodity and vice-versa cannot be sustained. This can be shown through Fig.2.

Fig 2.
Even in Fig the opportunity cost curves PQ and P1Q1 indicate that country A is capital-
abundant and country B is labour-abundant. The pattern of demand is different in the two
countries. The community indifference curves A1, A2 and A3 indicate demand pattern in
country A and the indifference curves B1, B2 and B3 indicate the deamd pattern in country
B. the iso- revenue curve demand pattern in country B. The iso-revenue curve SS1 related to
country A is less steep than the iso-revenue curve TT1 for country B, therefore

Now demand conditions indicate that machines are costly in country A while cloth is costly
in country B. Therfore, country A may decide to export cloth and country B may export
machines. So the pattern of demand may off-set the Hecksher-Ohlin generalisation that
capital-abundant country will export capital-intensive commodity and vice-versa.

2) The price criterion of relative factor abundance.

The alternative criterion for defining relative factor-abundance is the price criterion. The
criterion lays down that a country having capital relatively cheap and labour relatively costly
is capital abundant and vice-versa, irrespective of the physical quantities of capital and labour
that they have. Country A can be called relatively capital abundant if

Here P denotes prices K and L signify capital and labour respectively. A and B indicate
countries A and B respectively. Similarly, country A can be regarded as labour-abundant and
capital-scarce, if

Now suppose country A is capital-abundant and labour-scarce, the interest rates will be
relatively low and wage rates will be relatively higher compared with interest rates and wage
rates in country B. Therefore, country A will decide to produce and export capital-intensive
commodity (say, cloth). Now this generalization can be proved through Fig 3
 Fig 3.
AB is the factor-price line for country A and A1B1 is the factor price line for country B. As
the slope AB is greater than that of A1B1, capital is relatively cheap in country A and labour
is relatively cheap in country B. It signifies that

Now the factor price line AB is tangent to the isoquant M of the capital-intensive commodity
machine at R. It means country A can produce certain number of units of machine, say 100
machines, by employing OK units of capital and OL units of labour is equal to AK amount of
capital. In other words, the cost of producing 100 machines in country A in terms of capital is
OA. The factor price line A2B2 of country B, is parallel to A1B1. It is tangent to the isoquant
M at S. It signifies that country B can produce 100 machines in country A in terms of capital
is OA. The factor price line A2B2 of country B, is parallel to A1B1. It is tangent to the
isoquant M at S. It signifies that country B can produce 100 machines by employing OK1
units of capital and OL1 units of labour. It means A2K1 units of capital are equal to OL1
units of labour and the total cost of producing 100 machines in country B is OA2 in terms of
capital. From this, the conclusion can be derived that the production of machine is more
capital-intensive in country A than in country B.
Similarly in the production of one unit of cloth (say, 1000 meters) in country A, OL2 units of
labour and OK2 units of capital are employed at R1, the point of tangency between country
A’s factor price line AB and the isoquant for cloth C representing 1000 meters of cloth.
Given this factor combination, OK2 units of capital are equal to BL2 units of labour and the
cost of producing 1000 meters of cloth in country A in terms of labour in OB. In country B,
given the factor price line A1B1, the point of tangency between A1B1 and isoquant C is S1.
Country B employs OK3 units of capital and OL3 units of labour for producing 1000 meters
of cloth. Now the quantity of capital OK3 equals B1L3 units of labour. The cost of producing
1000 meters of cloth in labour is labour terms is OB1 in country B. This shows that labour-
abundant country B make more use of labour in producing 1000 meters of cloth than country
A. B will specialise in the production and export of cloth while country A export more
capital-intensive commodity machine.

FACTOR INTENSITIES
The Hecksher-Ohlin theory attributed the comparative differences in cost also to the factor
intensities which have been defined by Ellsworth as “relative use made of each one of the two
(or more) factors when combined in production.” Alternatively, factor intensity means the
relative proportions in which two factors, say labour and capital, are combined at each point
on a given isoquant. This explained through Fig 4.

Fig 4.
C and M in Fig 7.4 represent the isoquants of cloth and machine respectively. They are not
identical otherwise they would have coincide. They intersect each other at R. That indicates
equal factor proportions in producing a given number of units of the two commodities. The
portions to the left and above R is capital-intensive and the portion below and to the right of
R is labour-intensive. Along isoquant M, the quantities of capital and labour used at R1 and
OK1 and OL1 respectively. At R2, these inputs are OK2 and OL3 to have the same output of
machines. Thus above and to the left of R, the factor combinations involve larger input of
capital than labour. The opposite is true on the combinations below and to the right of R. The
same applies even in the case of isoquant C. If OK1 quantity of capital is used, one unit of
machine requires the labour input of OL1 but one unit of cloth requires OL2 of labour along
with OK1 units of capital at point S1. Similarly if OK2 units of capital are employed, one
machine can be turned out when labour input is OL3. At S2. One unit of cloth needs OL3
labour input along with a smaller capital input OK3. It clearly shows that machine is a
capital-intensive and cloth is a labour-intensive commodity, throughout the length of
isoquants M and C except of course at the point of intersection R.
So the relative factor abundance and factor intensity together determine the comparative
differences in costs and accordingly the countries will decide about specialisation and export
of specific commodities. On the basis of factor proportions, factor prices, Hecksher and Ohlin
made the generalisation that capital-intensive commodities and labour-abundant countries
will export labour-intensive commodities.

CRITICISM
No doubt, the Hecksher-Ohlin theory has been found to be more exact, precise, scientific and
analytically superior to the earlier approaches to the theory of international trade, still it has
certain deficiencies for which it has been criticized by many a writer.
1. Partial Equilibrium Analysis
Herberler although recognised Ohlin’s theory as less abstract, yet it has failed to
develop a general equilibrium concept. It remains, by and large, a part of the partial
equilibrium analysis. This theory seeks to explain the pattern of trade only on the
basis of factor proportions and factor intensities, while ignoring several other
influences such as transport costs, economies of scale, external economies etc, which
too exert influence on the cost of production. Ellsworth states that “with several
causes operating simultaneously upon cost, it becomes a matter of adding up the
influence of all costs-reducing and increasing forces to arrive at a net result.

2. Over simplifying assumptions

This theory is based upon highly over simplifying assumptions of perfect competition,
full employment of resources, identical production function, constant returns to scale,
absence of transport costs and absence of product differentiation. Given this set of
assumptions, the whole model becomes quite unrealistic.

3. Static analysis
The Heckscher-Ohlin assumes fixed quantities of factors of production, given
production functions, income and costs. It means the theory investigates the pattern of
international trade in a static setting. The conclusion drawn from such an analysis are
simply not relevant to a dynamic economic system.

4. Identical factors
This theory maintains that there are no qualitative differences in factors and that these
factors are capable of exact measurements so that endowment ratios can be calculated.
In the real world, however, qualitative factor differences do not exist. Moreover, there
are more than one variety of each factor. This creates serious complications in the
measurement and comparisons of costs and the determinations of trade patterns.

5. Neglect of product differentiations

The theory overlooks the role played by product differentiation in international trade.
Even when the production agents are identical two countries, the international trade
may still take place due to product differentiation. For instance, the Japanese
machines are sold out in U.S.A. and the American machines are sold in Japan. In this
context, Wijanholds opines that factor prices do not determine costs. It is rather the
commodity prices that determines factor prices. Prices of goods are determined by
their utility to the buyers (the force of demand) and the prices of factors like raw
material, labour etc, are ultimately dependent upon the demand and the prices of the
final goods because demand from them is derived demand. So Wijanholds states that
 “prices are the only thing we may accept as data. Everything else is to be derived
therefrom. He regards both Recardian theory and Hecksher-Ohlin theory as faulty as
they relate costs to factor prices and neglected the influence of product differentiation
on international trade.

6. Factor proportions and specialisation

The H-O theory that the relative factor proportions (or factor endowments) determine
the specialisation in exports of different countries. The capital- abundant countries
exports capital-intensive goods and labour-abundant countries export labour-intensive
goods. It implies that trade will not take place between such countries or regions as
have similar relative factor proportions. But this is not true. A large part of world
trade is between the U.S.A. and the countries of Western Europe despite the fact that
all of them have a relative greater capital-abundance and scarcity of labour. The H-O
theory cannot provide a complete and satisfactory explanation of trade in such cases.
In fact, the specialisation is governed not only by factor proportions but also by
several other factors like cost and price differences, transport costs, economies of
scale, external economies etc. the H-O theory was clearly wrong in overlooking these
factors.

7. Neglect of factor demand

The H-O theory assumes that the factor prices are determined by the relative factor
endowments of a country. It means the rate of interest should be relatively low and
wage rates relatively high in a capital-abundant but a labour-scarce country. On this
basis, the United States should have a lower structure of interest rate but it is in fact
higher because even in that capital-surplus country, the demand for capital too is very
strong. In fact, the relative factor prices are influenced not inly by their supply but
also by the demand for demand. The H-O theory failed to take into account the
influence of demand for factors on their prices.

8. Factor mobility
This theory assumes that there is absence of international mobility of factors. This
assumption is not valid. The writers like Williams and Levin have pointed out that the
international mobility of factors is actually even more than international mobility
within the same countries. This is evident from the international capital flows from
advanced countries to such exports sectors in LDC’s as petroleum, minerals,
plantation etc. Similarly the large-scale movement of labour from the Third World
countries to the advanced countries has assisted the latter in enlarging their production
and export. It is, therefore, clear that H-O theory an unrealistic assumption of
international immobility of factors.

9. Neglect of technological change

 The H-O model assumes identical production function. It implies that the
technological conditions in a given country remain unchanged. This assumption again
is invalid. There has been continuous improvement in techniques of production both
in the advanced and the less developed countries. The neglect of technological change
in H-O theory makes this model quite inconsistent with actual reality.

10. Factor intensity

This theory much prominence to the concept of factor intensity. It is assumed in this
model that one good is capital intensive and the other is labour-intensive. The capital-
intensive good remains capital-intensive in both the countries and the labour-intensive
good remains in both the countries. It means there can be no reversal of factor
intensity i.e., the same good is capital-intensive in one country while labour-intensive
in the other country. The empirical evidence on this issue is conflicting. However, if
there is reversal of factor-intensity, the whole structure of H-O theory will collapse.

11. Neglect of by-products

Sometimes by-products are even more important than the final product. The
Heckscher-Ohlin theorem, however, provides no explanation how the term of trade
are determined in the case of by-product.

12. Possibility of trade even under identical proportions

The factor proportions theory implies that there can be no possibility of international
trade when factor proportions between two countries are identical. In fact the identical
factor proportions may not close the possibility of trade if consumer preferences are
not identical due to differences in income distribution in two countries. This can be
explained through Fig. 5.

Fig 5

Given the identical factor production in two countries A and B, there is the same
production possibility curve PQ for both the countries. A1 and A2 are the community
 indifferences curves of A. B1 and B2 are the indifference curve of B. in the absence
of international trade, consumption points of the two countries are respectively R1
and S1. It shows that country A and country B has a greater preference for cloth. As
international trade takes place, TT1 is the international exchange ratio line. Now both
the countries get superior alternatives at R2 and S2 respectively. At R2, country A
consumes R2M of machines and OM of cloth. On the other hand, country B consumes
S2N quantity of cloth and ON quantity of machines at S2. The consumption in excess
of production is met through mutual imports. Thus even when the factor proportions
are identical, the international trade may still occur and that vitiates from the
Heckscher – Ohlin theory.

13. Vague theory

No doubt H-O theory attempted to explain the basis reason for comparative advantage
of the trading countries, yet the theory is vague and conditional. It depends upon
several restrictive and unrealistic assumptions. In the words of Harberler, “with many
factors of production, some of which are qualitatively incommensurable as between
different countries, and with dissimilar, no production function in different countries,
no sweeping a priori generalisations, concerning the composition of trade are
possible.’ Undoubtably, this theory is based upon some unrealistic assumptions, yet
Lancaster regards it as of central importance in the theory of international trade
because of its objectivity and simplicity. According to him, “…. Model occupies the
very centre of international trade theory, for reasons unconnected with its realism, and
indeed strengthened by the very properties which have been subject to so much
criticism.” He goes on further to comment, “it is in fact’ the simple model of
indifference curve is the simple model of consumer’s behaviour.”

CONCLUSION
The structure of the modern theory of international trade rests fundamentally upon the theory
developed by Eli Heckscher and Bertlin Ohlin. This theory has almost completely replaced
the classical and neo-classical theories related to international trade. But it does mean that
there is some real conflict between the Heckscher-Ohlin approach and the comparative costs
approach or that the former, in any way, invalidates the latter. In fact, the Heckscher-Ohlin
approach supplements the traditional approach in a powerful manner.

ENDNOTES
 BOOKS
 K.C. Rana, K.N. Verma, International Economics.
 H G Mannur, International Economics (2nd ed.)