Page 59 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 4 : Modern Theories of International Trade : Theorem of Factor Price Equalization, H-O Theory, Kravis and...

Likewise, country B specializes in the production of cloth; it produces at point G. But it consumes at Notes
point G in response to its utility pattern represented by the indifference curve IC . Therefore, it exports
B
BF amount of steel and imports FG amount of cloth. Once again we notice that country B, which is a
labour-surplus country exports capital-intensive good (steel) and imports labour-intensive good (cloth).
The Heckscher-Ohlin prediction is overturned.
In this case, represented in Figure 4.10, we have a situation of what is sometimes described as “demand
reversal”. Here, not only the two biases—consumption and production—are in the same direction
but also the consumption bias more than offsets the production bias. Consumption point D lies to the
left of production point A in country A; and in country B the consumption point G lies to the right of
the production point B. When such a demand reversal takes place, the capital surplus country would
export labour-intensive good and the labour-surplus country would export the capital intensive good.
The Heckscher-Ohlin prediction would then be invalidated by the demand reversal.
To sum it up : factor abundance can be defined in two ways in the Heckscher-Ohlin trade model. The
two definitions are not equivalent. Only according to the price criterion, the prediction of the model
would be valid. If the physical criterion is used, the prediction will be valid only if the demand
reversal does not take place.
Critical Evaluation of the Heckscher-Ohlin Theorem

In the area of pure theory of international trade, the Heckscher-Ohlin model occupies a very prestigious
position. The very fact that many well-known economists like Leontief, Walters, Minhas and others
have tried to test the empirical validity of the Heckscher-Ohlin theorem using econometric models,
stands as a testimony of the prestige of the model. Bertil Ohlin was also awarded a Nobel Prize in
Economics for his contribution to the pure theory of trade in the year 1978.
Although the factor proportions theorem developed by Heckscher and Ohlin provides a thorough
and plausible explanation of international trade as compared with the classical comparative advantage
model, yet it is not free from criticism. We have already seen how the Heckscher-Ohlin theorem will
turn out to be invalid when the demand reversal takes place. We will, therefore, examine only the
first two lines of criticism in what follows.

The Heckscher-Ohlin theorem has been criticized mainly along the following three lines:
(a) Factor intensity reversal argument; (b) Leontief Paradox, i.e. the results obtained by
empirical tests conducted by Leontief and others; and (c) Demand reversal argument.

Factor Intensity Reversal Argument
The Heckscher-Ohlin theorem was based on the assumption that the production functions are different
for different goods but they are identical for each good in the two countries. This, in other words,
meant that one good is capital intensive (with higher capital-labour ratio) and the other good is
labour-intensive (with lower capital-labour ratio); but the same good, which is capital-intensive in
one country, must be capital intensive in the other country also, and the labour intensive good remains
labour intensive in both the countries. This assumption is guaranteed when the two production
isoquants—for the capital-intensive and the labour intensive goods—cut each other only once but
not more than once. In Figure 4.7, this is shown to happen at point Q. The demonstration in
Figure 4.7 is consistent with the Heckscher-Ohlin assumption of non-reversability of factor intensities.
What will be the effect if the factor-intensity reversal takes place ? If it does take place, then the two
isoquants would cut each other more than once and the Heckscher-Ohlin theorem would turn out to
be invalid. This case is demonstrated in Figure 4.7.
The two production isoquants for steel and cloth cut each other twice in the succeeding diagram—
once at point A and the second time at point B. Now let us see the results. The factor price ratios in
country A (capital surplus country) are represented by the parallel lines P P . P P represent the
0 0 1 1
factor price ratios in country B (labour surplus country). This is as in Figure 4.7 also.

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