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

other country is labour abundant (or labour rich). The question is, what is meant by ‘factor Notes
abundance’ ? Two alternative definitions have been given for the term ‘factor abundance’.
• The first comprehensive and detailed examination of the Hecksher-Ohlin theorem was the one
undertaken by Leontief. You will recall that the theory of factor proportions predicted that the
capital abundant country exported capital-intensive goods and imported labour-intensive goods,
and the labour surplus country did the opposite.
• The non-availability explains international trade by the fact that each country imports the
goods that are not available at home. This unavailability may be due to lack of natural resources
(oil, gold, etc. : this is absolute unavailability) or to the fact that the goods cannot be produced
domestically, or could only be produced at prohibitive costs (for technological or other reasons):
this is relative unavailability. On the other hand, each country exports the goods that are available
at home.
• The hypothesis was proposed by economist Staffan Burenstam Linder in 1961 as a possible
resolution to the Leontief paradox, which questioned the empirical validity of the Heckscher-
Ohlin theory (H-O). H-O predicts that patterns of international trade will be determined by the
relative factor-endowments of different nations. Those with relatively high levels of capital in
relation to labor would be expected to produce capital-intensive goods while those with an
abundance of labor relative to (immobile) capital would be expected to produce labor intensive
goods. H-O and other theories of factor-endowment based trade had dominated the field of
international economics until Leontief performed a study empirically rejecting H-O. In fact,
Leontief found that the United States (then the most capital abundant nation) exported primarily
labor-intensive goods. Linder proposed an alternative theory of trade that was consistent with
Leontief’s findings. The Linder hypothesis presents a demand based theory of trade in contrast
to the usual supply based theories involving factor endowments. Linder hypothesized that
nations with similar demands would develop similar industries. These nations would then
trade with each other in similar, but differentiated goods.

4.5 Key-Words

1. Labour surplus : Surplus labour is a concept used by Karl Marx in his critique of
political economy. It means labour performed in excess of the labour
necessary to produce the means of livelihood of the worker
("necessary labour"). According to Marxian economics, surplus
labour is usually "unpaid labour". Marxian economics regards
surplus labour as the ultimate source of capitalist profits.
2. Factor price equalization : Factor price equalization is an economic theory, by Paul A. Samuelson
(1948), which states that the prices of identical factors of production,
such as the wage rate, or the return to capital, will be equalized across
countries as a result of international trade in commodities. The
theorem assumes that there are two goods and two factors of
production, for example capital and labour. Other key assumptions
of the theorem are that each country faces the same commodity prices,
because of free trade in commodities, uses the same technology for
production, and produces both goods. Crucially these assumptions
result in factor prices being equalized across countries without the
need for factor mobility, such as migration of labor or capital flows.
4.6 Review Questions

1. Discuss the modern theories of international trade.
2. Explain the theorem of factor price equalization .

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