Page 54 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes This would, in the end, mean that the absolute income share of labour will go up and that of capital
will go down. Trade will, therefore, increase the welfare of the factor of production which is used
intensively in the expanding industry, while the factor of production used intensively in the contracting
(or import-competing) industry will suffer loss of welfare as a result of trade. In other words, trade
increases the welfare of the abundant factor.
4.2 The Heckscher-Ohlin Theorem (H-O Theory)

Recent contributions to the pure theory of international trade have relied heavily on the factor
proportions analysis developed by the two Swedish economists, Eli Heckscher (1919) and Bertil Ohlin
(1933). According to their theory, the immediate cause of international trade is, the differences in the
relative prices of commodities between the countries, and these differences in the commodity prices
arise on account of the differences in the factor supplies in the two countries.
The Heckscher-Ohlin model is based upon the following postulates :
1. There are only two factors of production—labour and capital.
2. There are only two countries and they differ in factor abundance, e.g. one country is capital
abundant but labour scarce and the other country is labour abundant but capital scarce. In
other words, the two countries differ in factor endowments.
3. There are only two commodities. Both goods involve the use of both factors. The production
functions are such that the relative factor intensities are the same for each good in the two
countries. In other words, regardless of what the factor proportions or factor prices are in the
two countries, one commodity is always capital intensive in both countries, and the other
commodity is labour intensive in both countries.
On the basis of these postulates, the Heckscher-Ohlin theorem predicted that the capital surplus
country specializes in the production and exports of capital intensive goods, and the labour surplus
country specializes in the production and exports of labour intensive goods. We will now proceed to
demonstrate this well-known structure of trade prediction of the Heckscher-Ohlin model.
Factor Abundance Defined : The Two Criteria
In the Heckscher-Ohlin model, the two countries are distinguished by the differences in factor
endowments or ‘factor abundance’ i.e. one country is capital abundant (or capital rich) and the other
country is labour abundant (or labour rich). The question is, what is meant by ‘factor abundance’ ?
Two alternative definitions have been given for the term ‘factor abundance’.
1. Factor abundance can be defined in terms of factor prices. According to this “price criterion” a
country in which capital is relatively cheap and labour is relatively more expensive, is regarded
as the capital abundant country, regardless of the physical quantities of capital and labour
available in this country compared with the other country. By the same token, a labour abundant
country would be defined as one where labour is relatively cheaper and capital is more expensive.
This criterion takes into account both the supply and demand conditions for the two factors of
production in the two countries. Ohlin uses the price criterion of the relative factor abundance,
but he argues that the differences in factor prices in the two countries, are due to differences in
factor supplies in the two countries. In other words, Ohlin believes that supply factor plays a
predominant role in determining the relative factor prices in a country.
2. Factor abundance can be defined in physical terms. According to the “physical criterion”, a
country is relatively capital abundant if and only if it is endowed with a higher proportion of
capital to labour than the other country. By the same token a labour abundant country is defined
as one which has more amount of labour and less amount of capital in physical terms.
This is a pure supply criterion, and it ignores the effects of demand conditions.
These two alternative definitions are not equivalent. The Heckscher-Ohlin prediction with regard to
the structure of trade would follow only if we use the price criterion, but it does not necessarily hold
good if we use the physical criterion to define factor abundance. Ohlin himself defined relative factor
abundance using the price criterion. He thought that if capital is relatively cheap in one country, that

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