Page 37 - DMGT545_INTERNATIONAL_BUSINESS

International Business

notes According to Heckscher-Ohlin Theory of International Trade, the immediate cause of international
trade is the difference in relative commodity prices. The cause of difference in the relative prices of
the goods is the difference in the amount of factor endowments, like capital and labour, between
the two countries. As a result, there is difference in the relative demand and supply of factors.
These differences cause difference in the prices of the factors. It is due to difference in factor
prices that difference in the relative prices of the commodities takes place and it is this difference
that constitutes the main cause of international trade.
Goods, which require scarce factors on a large-scale are imported because their domestic prices
are high. On the contrary, goods, which require abundant factors on a large scale, are exported
as their domestic prices are low. For instance, if capital is abundant in USA, it will be relatively
cheap. Hence, USA will export those goods which are capital intensive. On the contrary, if labour
is abundant in India, it will be relatively cheap. Hence, India will export those goods which are
labour intensive.

Notes International trade takes place because of diversity in factor endowments and
hence difference in prices.

2.4.2 concept of relative factor endowment

Abundance or scarcity of factors of Heckscher-Ohlin theory has been explained on the basis of
two criterions:

Price criterion of relative factor endowment

Price criterion of factor endowment means that a country where capital is relatively cheap and
labour relatively dear will be called capital abundant country, even if the quantity of capital in
that country is relatively less. On the contrary, if capital is relatively dear and labour relatively
cheap, such a country will be called capital scarce country, even if the quantity of capital in such
a country is relatively more. In other words, the criterion of factor abundance or factor scarcity
is not the quantum of the factor but its price. On the basis of price criterion, international trade
theory can be explained with the help of an example.

Example:

Diagrammatic Explanation

Let us take USA and India as two trading countries. It is assumed that USA is a capital intensive
country and India is a labour intensive country, i.e., capital is cheaper in USA in relation to
labour; and labour is cheaper in India in relation to capital. This can be expressed in terms of the
following equation:

USA India

PK < PK
P L P L
Here, P price of capital; P : price of labour; < : less than
K: L
Both the countries are producing watches and shirts. While the production of watches is capital
intensive, the production of shirts is labour intensive. According to Heckscher-Ohlin theory,
India should specialise in the production of shirts and USA should specialise in the production
of watches. This is illustrated in Figure 2.3.

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