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Unit 2: Theories of International Trade

assumptions of the theory notes

Some of the assumptions of the theory are discussed below:
1. This theory relates to two countries, two commodities and two factors. It is therefore called
2 × 2 × 2 model.
2. There is same production function for each commodity in two countries.
3. Factors are mobile within the country but immobile between two countries.
4. There is perfect competition in all markets. As a result (i) all factors are fully employed, (ii)
factors get their reward in accordance with their marginal productivity, (iii) prices of the
commodities are equal to their marginal productivity.
5. No restriction is imposed on the exchange of goods, i.e., free trade exists between two
countries.
6. Consumers’ tastes and preferences are identical in two countries.
7. Technique of production employed in two countries is the same.

8. There is lack of transport costs.
9. Factor endowments are different in two countries.
10. Goods can be classified on the basis of factor intensity, such as, capital intensive goods and
labour intensive goods, etc.
11. Production function of all goods is homogeneous of the first degree. It means that output
will be doubled if all factors of production are doubled.

Did u know? Swedish economists Eli Heckscher and Bertil Ohlin developed “Factor
proportion theory of International Trade” in year 1919.
2.4.1 explanation of the theory

According to Ohlin “International Trade is but a special case of inter-regional trade.” Different regions
have different factor endowments, i.e., some regions have abundance of labour but scarcity of
capital while other regions have abundance of capital but scarcity of labour. Different goods have
different production functions, i.e., factors are combined in different proportions to produce
different commodities. Some goods are produced by employing relatively large proportion of
labour and relatively small proportion of capital. Still other goods are produced by employing
relatively small proportion of labour and relatively large proportion of capital. In this way,
each region is suitable for the production of those goods for whose production it has relatively
abundant supply of the required factors. A region is not suitable for the production of those
goods for whose, production it has relatively scarce or zero supply of the essential factors. Hence,
different regions have different capacity to produce different commodities. Difference in factor
endowments is, therefore, the main cause of international trade along with inter-regional trade.
According to Ohlin, “Immediate cause of inter-regional trade is always that goods can be bought
cheaper in terms of money than they can be produced at home and here is the case of international trade.”
Heckscher in his article, “The effect of Foreign Trade on the Distribution of Income” published in
1919 had supported the classical theory of comparative costs and maintained that international
trade took place because of differences in comparative costs. But classical theory did not explain
why there was difference in comparative costs. Answering to this question, Heckscher cites the
following causes for difference in comparative costs:
1. Difference in factor endowments
2. Difference in factor intensities

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