In The Heckscher-Ohlin Model O Essay, Research Paper

The Heckscher-Ohlin model of trade, proposed by two Swedish economists Hecksher and Ohlin, is based on the differences of factor requirements in commodities and difference in relative factor endowments. It believes that these factors explain the cause of trade. According to the Heckscher-Ohlin theory, it predicts that countries will export those goods that make intensive use of factors of production, which are locally abundant, while importing goods that make intensive use of factors that are locally scarce (Salvatore, 1995). It extends the trade model to examine the basis for comparative advantage and the effects that international trade have on factor earnings in the nations. This essay will focus on how the Heckscher-Ohlin model of trades determines a country’s comparative advantage. As an example of this model, two countries will be analysed, particularly on change patterns of trade in the country. Finally, this essay will outline briefly the alternative models that can be used under the same condition.

A few basic assumptions of the Heckscher-Ohlin model or known as “2×2x2″ model because of the assumption that there are two countries with different factor endowments with two homogenous factors labour and capital, as the only factor production and produces two products differing in their relative factor intensity. The other assumptions are that the market is perfectly competitive, there are no transportation costs, taste and preferences are identical for both countries have the same capability in terms of technology.

What determines a country’s comparative advantage?

Comparative advantage is a principle which stated that it will pay the country to produce more of those goods in which it is relatively more efficient and to export them in return for goods in which its relative advantage is least. The assumptions that have previously been outlined need to be analysed in order to explain the determinants for a country’s comparative advantage using the Heckscher-Ohlin model. When there are two countries with different relative prices in autarky, then there is a basis for trade because of different factor endowments. In other words, factor endowments determine what country should produce and export and what it should import. Thus, the difference in factor endowments (in the face of equal technology and taste) is a basic determinant of comparative advantage and forms the basis for mutually beneficial trade.

Factor endowment for a country can be viewed in two ways, namely; the physical and price definition. Physical definition usually uses labour and capital as the key indicator for comparison. To determine which country is capital abundant and which is labour abundant, the ratio of the countries capital to labour need to be calculated. First, assume two factors of production, K and L, and two countries, A and B. Each country is capable of producing both of the two goods, X and Y. One country is assumed to be capital-abundant and the other country is labour-abundant. If country A has more capital per unit of labour than country B, then (KA/LA)>(KB/LB). So country B must have more labour per unit of capital than country A, (LB/KB)>(LA/KA). Thus labour is relatively cheap in country B and capital is relatively cheap in country A.

As an illustration, two countries were chosen for comparison, there are Australia and China. Obviously, Australia and China have different factor endowment. The former with a population of approximately 19 million should be a capital abundant country compare to China with a population of 1 billion. Therefore, from the example above, Australia ratio of capital to labour is greater than China, hence Australia is a capital abundant country. Thus Australia has a comparative advantage in terms of capital and China is advantageous in its labour. Meanwhile, price definition compare the relative prices of capital and labour in those two countries to determine their factor abundance. According to the Heckscher-Ohlin model, a country is a capital abundant country if it prices of capital to labour is less than the prices in the other country. Australia is still a capital abundant country because when technology, tastes and preferences of the both countries are the same, then the country with a higher Capital/Labour ratio will have a relatively smaller rent/wage ratio.

After the determination of a country’s factor abundance, then the country should produce and specialise in the production of the good that suit is factor abundant. Based on the example above, China should produce a labour intensive product such as cloths. Meanwhile, Australia should specialise in the production of a capital-intensive product such as steel. These goods are said to be capital intensive goods because they require relatively more capital than labour in their production. From this factor the mutual gain from trade exist when China export cloths to Australia and import steel from it and vice versa.

Hence, a mutual gain from trade exists when both countries have equality in import and export. And both countries will get higher indifferent curve indicating a gain from trade, as shown in the diagram above. Thus, it is evident that when there are two countries with different relative prices in autarky, generally there is a basis for trade because of the different factor endowments.

What other models of trade might be useful in this regard?

There are few models of alternative theories of trade yield due to other factors not accounted for by the standard Heckscher-Ohlin model. The first factor is technology theories, which are extracted from Imitation Lag Hypothesis and Product Cycle Hypothesis. For Imitation Lag Hypothesis, it examines the implications of allowing for delays in the diffusion of technology across country borders. It assumes that the same technology is not always available in all countries. An example using Australia and China where we assume that Australia has a comparative advantage in research and developments and tends to export technologically advanced manufactured goods. The Product Cycle Hypothesis suggests three product stages (new product, maturing product, and standardised product). The trade occurs when this hypothesis can postulate a dynamic comparative advantage because the country’s source of export shifts from leading developed countries as the product moves from its introduction to maturity and standardisation. The implications of this theory will effect a developing country which in this case is China in that it will be confined to exporting older products as opposed to new high-technology goods.

The second factor is demand theories based on Linder Thesis and Krugman model. Linder thesis is a demand-oriented theory instead of supply oriented as introduced by Hecksher-Ohlin. This theory explains that a country’s per capita income level yields a pattern of tastes that will generate demand and subsequently determine the level of production. In other words, the type of goods produced depends on the country per capita income level. Thus each country will produce good that suit the demand and taste of its citizen. If there is a trade between two countries, the goods demanded by consumers in both countries will be traded. This theory will increase trade between countries of similar income levels.

The last factor is economies of scale, which originated from the Kemp and Krugman model. The Krugman model introduce economies of scale and monopolistic competition. The economic scale or increasing returns to scale exists when doubling the input (labour, capital) increase the output quantity by declining the average cost of production. The monopolistic competition suggests that product differentiation can be a basis for a successful exporting. It believes that this factor will lead to some uncertainties to trade patterns but suggest potentially large gains from trade for countries with identical taste and preferences. Hence each country would significantly gain by this form of trade.

In conclusion, this theory is applicable for a product differentiated country. Therefore, the Heckscher-Ohlin model is a fundamental theorem in explaining the basis for international trade between two countries with different factor endowments. It is important to note however, that in order to develop and improve trade theories, one must work on establishing a better theory of how new technologies and new knowledge in general, arises.

REFERENCES:

1) Appelyard, D.R and Field, A.J, 2nd Edition, International Economics, Irwin.

2) Lindert, P (1996), 10th Edition, International Economics, Irwin.

3) Salvatore D, 5th Edition, International Economics, Prentice Hall.

4) Walther, T. (1997), The World of Economy, John Wiley & Sons, Inc.