FACTOR ENDOWMENTS AND

THE HECKSCHER–OHLIN THEORY

PREVIEW
H-O theorem: Factor endowments
and trade

H-O-S: Factor – Price Equalization

Theorem

Empirical tests on H-O theory

HECKSCHER & OHLIN

Eli Heckscher Bertil Ohlin

(1879-1952) (1899-1979)
INTRODUCTION
• Ricardian Model: L is the only factor and comparative advantage
arises due to productivity differences.
• But this cannot be the only reason that nations trade.
• E.g., Saudi Arabia X oil to U.S., not because its oil-field workers are more
productive but because Saudi Arabia has more oil!
• A more realistic view of trade incorporates differences in
resources (e.g., T, L, K, and minerals).
INTRODUCTION (cont.)
• H-O is called the “factor-proportions” theory because of its
emphasis on the importance of factors available to the country and
the proportions of factors required to produce different goods.
• To study H-O:
• First, determine how factor-proportions theory works in an economy that
does not trade.
• Then examine what happens when trade between 2 countries occurs.
INTRODUCTION (cont.)
• In H-O:
• Differences in resources are the only source of trade.
• Comparative advantage is determined by the relative
abundance of the factors of production and the technology,
which determines the relative intensity with which different
factors are used in the production of each good.
 1. H-O THEOREM: FACTOR
ENDOWMENTS AND TRADE
ASSUMPTIONS OF THE H-O MODEL
1. 2x2x2 Model: 02 nations, 02 commodities (X and Y), 02 factors of production
(labor - L and capital - K)
2. The same technology in production
3. Commodity X is labor intensive, commodity Y is capital intensive in both nations
4. Constant returns to scale for X and Y in both nations
5. Incomplete specialization in production in both nations
6. Equal tastes in both nations
7. Perfect competition in both commodities and factor markets
8. Perfect factor mobility within each nation but no international factor mobility
9. No transportation costs, tariffs or other barriers to free trade
10. All resources are fully employed in both nations
11. International trade between the nations in balance
THE BASIS FOR TRADE
• The basis for trade: comparative advantage
• Sources of comparative advantage: Factor endowment (resources
that a country has access to)
• A country has a comparative advantage in producing a good that
intensively uses the factor that this country is relatively
abundant.
• Factor intensity: the importance of one factor versus others in
production in a good.
• Factor abundance: the availability of a country’s factor of production
FACTOR INTENSITY
• Two commodities (X and Y) and two factors (L and K)
• Y is capital intensive if the capital-labour ratio (K/L) used in the
production of Y is greater than the K/L used in the production of X
(Y) OR (Y)
• It is not the absolute amount of capital and labor used in the
production of X and Y, but the amount of capital per unit of labor
that determines the capital intensity.
FACTOR ABUNDANCE
2 ways to determine the factor abundance
• 1st way: Determine based on the number of factors
– A country is capital abundant if the ratio of the total amount of
capital to the total labour (TK/TL) available in this country is more
significant than that in the other country.
(N1)> (N2)
– It is not the absolute amount of capital and labor available in each
nation, but the ratio of the total amount of capital to the total
amount of labor.
FACTOR ABUNDANCE (CONT.)
FACTOR OF
VIETNAM PRODUCTION THE U.S
USD 262 bil. Total capital (TK) USD 21,430 bil.
55 mil. Total labor (TL) 160 mil.
~4,763 TK/TL ~134,000

• The U.S. is abundant in capital

• Vietnam is abundant in labor
Factor abundance (cont.)
• 2nd way: Determine based on the factor price
 Price of labor time (PL): w
 Rental price of capital (PK): r
 A country is capital abundant if the ratio of the rental price of capital to the price of
labor time (PK/PL) is lower in this country than in the other country

( ( OR )
THE PATTERN OF TRADE
•H-O theorem: A country will specialize and export the good that is
intensive in the country’s relatively abundant factor and import the good
that is intensive in the country’s relatively scare factor.

Abundant in labor Labor -

intensive
Abundant in capital

Capital - intensive
PRODUCTION POSSIBILITIES FRONTIER (PPF)
• PPF with increasing opportunity cost
• Country 1 has to give up more and more Y to
produce an additional 20 units of X
• Country 2 has to give up more and more X to
produce an additional 20 units of Y
• PPF: supply side
COMMUNITY INDIFFERENCE CURVE (CIC)
• CIC shows the various combinations of X and Y that yield equal satisfaction to
the community/nation -> the community is indifferent to any two points on
the same CIC.
• A higher CIC equals to a higher level of satisfaction.
• CIC: demand side

C • A, B: the same satisfaction -> trade-off

D • C: higher satisfaction than A, B
A
• D: higher satisfaction than C
B
GAINS FROM TRADE
• Each country produces at the point where PPF is
In autarky
tangent to the highest possible CIC.
• 2 nations have the same CIC (Assumption of the same
taste in 2 nations).
• Nation 1 produces at point A and Nation 2 produces at
point with respective prices of PA and PA’

• PA = the slope of the tangent between

CIC and PPF1

• PA’ = the slope of the tangent

between CIC and PPF2
• PA < PA’: Nation 1 has comparative advantage in
producing X and nation 2 has comparative advantage
in producing Y.
GAINS FROM TRADE (CONT.)
Before trade After trade:
Exchange BC units of X
for B’C’ units of Y
Production Consumption Production Consumption
Nation 1 A A B B’
Nation 2 A’ A’ E E’

• E, E’ lie on CIC II - higher utility for consumers

I than CIC I.
• Both nations benefit from trade.
GAINS FROM TRADE (CONT.)
With trade H-O THEOREM
Incomplete specialization
Nation 1 specializes Nation 2 specializes
in X, exports X and in Y, exports Y and
imports Y imports X

Relative prices are equal

Nation 1 produces Nation 2 produces

I
at point B at point B’

PB=PB’= the slope of common

tangent of 2 PPFs
SPECIALIZATION UNDER CONSTANT VS.
INCREASING OPPORTUNITY COST
• Constant opportunity cost: Complete specialization
• Long-lasting and unchanged comparative advantage
• Increasing opportunity cost: Incomplete/ Partial specialization
• Increasing OC causes countries to lose their comparative advantage over
time.
• Specialization only occurs until the OC are equal in both countries.
2. H-O-S: FACTOR – PRICE
EQUALIZATION THEOREM
 ILLUSTRATION OF H-O-S THEOREM
Home Foreign

Without Relatively abundant in L Relatively abundant in K

trade w: low; r: high -> w/r low w: high; r: low -> w/r high

Specialize in production of X (labor

intensive) Specialize in production of Y (capital
Demand for labor increases & Demand intensive) Demand for labor decreases,
for capital decreases Demand for capital increases
-> w increases, r decreases -> w decreases, r increases
With trade -> w/r decreases
-> w/r increases

• Owners of abundant factor will gain. Owners of scarce factor will lose
• Trade brings benefits to both countrie, but within a country, there will be a
Implications group that benefits and there will be a group that suffers from trade.
3. EMPIRICAL TESTS ON
H-O THEORY
THE LEONTIEF PARADOX
Tests on US data
• The US is the most capital-abundant country
• US exports were less capital-intensive than US imports, Leontief paradox.
Tests on global data
• Bowen, Leamer, and Sveikauskas tested the Heckscher- Ohlin model on data
from 27 countries and confirmed the Leontief paradox on an international
level.
• Tests on manufacturing data between low/middle income countries and high-
income countries.
• This data lends more support to the theory.
THE LEONTIEF PARADOX (cont.)
SOURCES OF THE LEONTIEF PARADOX BIAS
• Assumed a two-factor world which required assumptions about
what is capital and what is labor.
• Most heavily protected industries in U.S. were labor intensive,
reduced imports and increased domestic production of labor-
intensive goods.
• Only physical capital included as capital, ignoring human capital
(education, job training, skills).
CONTRIBUTIONS AND LIMITATIONS
• Contributions
• Explain the source of comparative advantage – the countries’
• difference in factor endowments
• Explain the impacts of international trade on income distributions
• Consider international trade under the increasing opportunity cost ->
incomplete specialization -> closer to reality.
• Both supply (PPF) and demand (CIC) sides are included.
• Limitations:
• Some empirical studies do not support this theory.
SUMMARY
• The Heckscher–Ohlin theory presented in this chapter extends our trade model of
previous chapters to explain the basis of (i.e., what determines) comparative advantage
and to examine the effect of international trade on the earnings of factors of production.
• H-O assumptions, H-O key terms: factor abundance, factor intensity
• The Heckscher–Ohlin, or factor-endowment, theory can be expressed in terms of two
theorems.
• According to the H–O theorem, a nation will export the commodity intensive in its
relatively abundant and cheap factor and import the commodity intensive in its
relatively scarce and expensive factor.
• According to the factor–price equalization (H–O–S) theorem, international trade will
bring about equalization of relative and absolute returns to homogeneous factors
across nations.
SUMMARY
• The Leontief paradox: U.S. import substitutes were about 30
percent more K intensive than U.S. exports in 1947  the
traditional Heckscher–Ohlin model can explain trade between
developed and developing countries and a highly qualified or
restricted version of the H–O can model the much larger trade
among developed countries.
KEY TERMS
• Capital-intensive commodity, p. 111
• Capital–labor ratio (K /L), p. 111
• Constant elasticity of substitution
(CES) production function, p. 151
• Constant returns to scale, p. 111
• Derived demand, p. 114
• Elasticity of substitution, p. 137
• Euler’s theorem, p. 145
• Factor abundance, p. 114
• Factor-intensity reversal, p. 137
• Factor–price equalization (H–O–S)
theorem, p. 124
• Factor-proportions or factor-
endowment theory, p. 118
• Heckscher–Ohlin (H–O) theorem, p. 118
• Heckscher–Ohlin (H–O) theory, p. 118
• Human capital, p. 134
• Import substitutes, p. 131
KEY TERMS
• Internal factor mobility, p. 111
• International factor mobility, p. 111
• Labor–capital ratio (L/K), p. 111
• Labor-intensive commodity, p. 111
• Leontief paradox, p. 132
• Relative factor prices, p. 114
• Specific-factors model, p. 128
A LOOK AHEAD

Part 1: Sources Of Trade, The

Trade Pattern, Gains From
Trade
PART 2: International Trade
Policy: Trade Restrictions:
Tariffs
THE END!