Heckscher-Ohlin model
Encyclopedia
The Heckscher–Ohlin model (H–O model) is a general equilibrium
mathematical model of international trade
, developed by Eli Heckscher
and Bertil Ohlin
at the Stockholm School of Economics
. It builds on David Ricardo's
theory of comparative advantage
by predicting patterns of commerce and production based on the factor
endowments of a trading region. The model essentially says that countries will export products that use their abundant and cheap factor(s) of production and import products that use the countries' scarce factor(s).
(land
, labor, and capital
) determine a country's comparative advantage. Countries have comparative advantages in those goods for which the required factors of production are relatively abundant locally. This is because the profitability
of goods is determined by input costs. Goods that require inputs that are locally abundant will be cheaper to produce than those goods that require inputs that are locally scarce.
For example, a country where capital and land are abundant but labor is scarce will have comparative advantage in goods that require lots of capital and land, but little labor — grains. If capital and land are abundant, their prices will be low. As they are the main factors used in the production of grain, the price of grain will also be low—and thus attractive for both local consumption and export. Labor intensive
goods on the other hand will be very expensive to produce since labor is scarce and its price is high. Therefore, the country is better off importing those goods.
has trade ultimately motivated by differences in labour productivity using different technologies. Heckscher and Ohlin didn't require production technology to vary between countries, so (in the interests of simplicity) the H-O model has identical production technology everywhere. Ricardo considered a single factor of production (labour) and would not have been able to produce comparative advantage without technological differences between countries (all nations would become autarkic at various stages of development, with no reason to trade with each other). The H-O model removed technology variations but introduced variable capital endowments, recreating endogenous
ly the inter-country variation of labour productivity that Ricardo had imposed exogenous
ly. With international variations in the capital endowment (i.e. infrastructure
) and goods requiring different factor proportions, Ricardo's comparative advantage emerges as a profit-maximizing solution of capitalist's choices from within the model's equations. (The decision capital owners are faced with is between investments in differing production technologies: The H-O model assumes capital is privately held.)
published the book which first explained the theory in 1933. Although he wrote the book alone, Heckscher was credited as co-developer of the model, because of his earlier work on the problem, and because many of the ideas in the final model came from Ohlin's doctoral thesis, supervised by Heckscher.
Interregional and International Trade itself was verbose, rather than being pared down to the mathematical, and appealed because of its new insights.
The model has variable factor proportions between countries: Highly developed countries have a comparatively high ratio of capital to labor in relation to developing countries. This makes the developed country capital-abundant relative to the developing nation, and the developing nation labor-abundant in relation to the developed country.
With this single difference, Ohlin was able to discuss the new mechanism of comparative advantage
, using just two goods and two technologies to produce them. (One technology would be a capital intensive
industry, the other a labor intensive business - see "assumptions" below).
s) in the hopes of increasing the model's predictive power, or as a mathematical way of discussing macroeconomic policy options.
Notable contributions came from Paul Samuelson
, Ronald Jones
, and Jaroslav Vanek
, so that variations of the model are sometimes called the Heckscher-Ohlin-Samuelson model or the Heckscher-Ohlin-Vanek model in the neo-classical economics.
is the same in both countries in the same technology with identical amounts of capital.
Countries have natural advantages in the production of various commodities in relation to one another, so this is an 'unrealistic' simplification designed to highlight the effect of variable factors. (This meant that the original HO-model produced an alternative explanation for free trade to Ricardo's, rather than a complementary one). In reality, both effects may occur (differences in technology and factor abundances).
In addition to natural advantages in the production of one sort of output over another (wine vs. rice, say) the infrastructure, education, culture, and 'know-how' of countries differ so dramatically that the idea of identical technologies is a theoretical notion. Ohlin said that the HO-model was a long run model, and that the conditions of industrial production are "everywhere the same" in the long run.
of degree 1').
These conditions are required to produce a mathematical equilibrium. With increasing returns to scale it would likely be more efficient for countries to specialize, but specialization is not possible with the Heckscher-Ohlin assumptions.
technologies the parameters applied to the inputs must vary. An example would be:
Where A is the output in arable
production, F is the output in fish production, and K, L are capital and labour in both cases.
In this example, the marginal return to an extra unit of capital is higher in the fishing industry, assuming units of F(ish) and A(rable) output have equal value. The more capital-abundant country may gain by developing its fishing fleet at the expense of its arable farms. Conversely, the workers available in the relatively labour-abundant country can be employed relatively more efficiently in arable farming.
argument of Ricardo, this is assumed to happen costlessly.
If the two production technologies are the arable industry and the fishing industry it is assumed that farmers can shift to work as fishermen with no cost, and vice versa.
For instance, if the two industries are farming and fishing it is assumed that farms can be sold to pay for the construction of fishing boats with no transaction costs.
(for investment) will make relative abundances identical throughout the world. (Essentially, Free Trade
in capital would provide a single worldwide investment pool.)
Differences in labour abundance would not produce a difference in relative factor abundance (in relation to mobile capital) because the labour/capital ratio would be identical everywhere. (A large country would receive twice as much investment as a small one, for instance, maximizing capitalist's return on investment
).
As capital controls are reduced, the modern world has begun to look a lot less like the world modelled by Heckscher and Ohlin. It has been argued that capital mobility undermines the case for Free Trade
itself, see: Capital mobility and comparative advantage Free trade critique. Capital is mobile when:
s, and no exchange controls (capital was immobile, but repatriation of foreign sales was costless). It was also free of transportation costs between the countries, or any other savings that would favour procuring a local supply.
If the two countries have separate currencies
, this does not affect the model in any way (Purchasing Power Parity
applies). Since there are no transaction costs or currency issues the law of one price
applies to both commodities, and consumers in either country pay exactly the same price for either good.
In Ohlin's day this assumption was a fairly neutral simplification, but economic changes and econometric research since the 1950s have shown that the local prices of goods tend to be correlated with incomes when both are converted at money prices (although this is less true with traded commodities). See: Penn effect
.
exists.
(as the H-O model assumes perfect competition where price is equal to the costs of factors of production). This theorem is useful in explaining the effects of immigration, emigration and foreign capital investment. However, Rybczynski suggests that a fixed quantity of the two factors of production are required. This could be expanded to consider factor substitution, in which case the increase in production would be more than proportional.
rate as well as decreasing the relative wage
rate (the return on capital as against the return to labour). Also if the price of labour intensive goods increases, it will increase the relative wage
rate as well as decreasing the relative rental
rate .
al return to capital, nor the wage
rates seem to consistently converge between trading partners at different levels of development.
, but took thirty years to develop completely because of the theoretical complexity involved.
Modern econometric estimates have shown the model to perform poorly, however, and adjustments have been suggested, most importantly the assumption that technology is not the same everywhere. (This change would mean abandoning the pure H–O model.)
. Alternative trade models and various explanations for the paradox have emerged as a result of the paradox. One such trade model, the Linder hypothesis
, suggests that goods are traded based on similar demand rather than differences in supply side factors (i.e.. H–O's factor endowments).
where Fc is the net trade of factor service vector for country c, Vc the factor endowment vector for country c, and sc the country c's share of the world consumption and V the world total endowment vector of factors. For many countries and many factors, it is possible to estimate the left hand sides and right hand sides independently. To put it another way, the right hand side tells the direction of factor service trade. Thus it is possible to ask how this system of equations holds. The results obtained by Bowen, Leamer and Sveiskaus (1987) was disastrous. They examined the cases of 12 factors and 27 countries for the year 1967. They found that the both sides of the equations had the same sign only for 61 percent out of 324 cases. For the year 1983, the result was more disastrous. Both sides had the same sign only for 148 cases out of 297 cases (or the rate of correct predictions was 49.8%). The results of Bowen, Leamer and Sveiskaus (1987) mean that the Hecksher–Ohlin–Vanek theory has no predictive power concerning the directions of trade.
A common understanding exists that in the national level HOV model fits well. In fact, Davis and others found that HOV model fitted extremely well with the regional data of Japan. Even when the HOV formula fits well, it does not mean that Heckscher–Ohlin theory is valid. Indeed, Heckscher–Ohlin theory claims that the state of factor endowments of each country (or each region) determines the production of each country (respectively of each region) but Bernstein and Weinstein found that the factor endowments have little predictive power. The factor-endowments-driven model (FED model) has errors much greater than HOV model.
Heckscher–Ohlin theory is badly adapted to the analyze South-North trade problems. The assumptions of HO are unrealistic with respect to North-South trade. Income differences between North and South is the concern that third world cares most. The factor price equalization theorem has not shown a sign of realization, even for a long time lag of a half century.
Usually by a system of prices. But prices are dependent of profit rate. In the Heckscher–Ohlin model, the rate of profit is determined according to how abundant capital is. If capital is scarce, it has a high rate of profit. If it is abundant, the profit rate is low. Here is a logical circle. Before the profit rate is determined, the amount of capital is not measured. This logical difficulty was the subject of academic controversy which took place many years ago. In fact, this is sometimes named Cambridge Capital Controversies
. The conclusion of the controversies was that the concept of homogeneous capital was untenable. Heckscher–Ohlin theorists ignore all these stories without providing any explanation how capital is measured theoretically.
emphasizes that firms are heterogeneous.
.
See also Intra-industry trade
.
Ricardian theory is now extended in a general form which includes not only labor but also inputs of materials and intermediate goods. In this sense, it is much general and plausible than the Heckscher–Ohlin model and escapes from the logical problems such as capital as endowments, which is in reality produced goods.
As the theory permits different production processes to coexist in an industry of a country, the Ricardo–Sraffa theory can give a theoretical bases for the New Trade Theory.
General equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...
mathematical model of international trade
International economics
International economics is concerned with the effects upon economic activity of international differences in productive resources and consumer preferences and the institutions that affect them...
, developed by Eli Heckscher
Eli Heckscher
Eli Filip Heckscher was a Swedish political economist and economic historian.-Biography:...
and Bertil Ohlin
Bertil Ohlin
Bertil Gotthard Ohlin was a Swedish economist and politician. He was a professor of economics at the Stockholm School of Economics from 1929 to 1965. He was also leader of the People's Party, a social-liberal party which at the time was the largest party in opposition to the governing Social...
at the Stockholm School of Economics
Stockholm School of Economics
The Stockholm School of Economics or Handelshögskolan i Stockholm is one of Northern Europe's leading business schools. Its Masters in Management program is ranked no. 2 in Northern Europe and no. 13 in Europe by the Financial Times...
. It builds on David Ricardo's
David Ricardo
David Ricardo was an English political economist, often credited with systematising economics, and was one of the most influential of the classical economists, along with Thomas Malthus, Adam Smith, and John Stuart Mill. He was also a member of Parliament, businessman, financier and speculator,...
theory of comparative advantage
Comparative advantage
In economics, the law of comparative advantage says that two countries will both gain from trade if, in the absence of trade, they have different relative costs for producing the same goods...
by predicting patterns of commerce and production based on the factor
Factors of production
In economics, factors of production means inputs and finished goods means output. Input determines the quantity of output i.e. output depends upon input. Input is the starting point and output is the end point of production process and such input-output relationship is called a production function...
endowments of a trading region. The model essentially says that countries will export products that use their abundant and cheap factor(s) of production and import products that use the countries' scarce factor(s).
Features of the model
Relative endowments of the factors of productionFactors of production
In economics, factors of production means inputs and finished goods means output. Input determines the quantity of output i.e. output depends upon input. Input is the starting point and output is the end point of production process and such input-output relationship is called a production function...
(land
Land (economics)
In economics, land comprises all naturally occurring resources whose supply is inherently fixed. Examples are any and all particular geographical locations, mineral deposits, and even geostationary orbit locations and portions of the electromagnetic spectrum. Natural resources are fundamental to...
, labor, and capital
Capital (economics)
In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...
) determine a country's comparative advantage. Countries have comparative advantages in those goods for which the required factors of production are relatively abundant locally. This is because the profitability
Profit (economics)
In economics, the term profit has two related but distinct meanings. Normal profit represents the total opportunity costs of a venture to an entrepreneur or investor, whilst economic profit In economics, the term profit has two related but distinct meanings. Normal profit represents the total...
of goods is determined by input costs. Goods that require inputs that are locally abundant will be cheaper to produce than those goods that require inputs that are locally scarce.
For example, a country where capital and land are abundant but labor is scarce will have comparative advantage in goods that require lots of capital and land, but little labor — grains. If capital and land are abundant, their prices will be low. As they are the main factors used in the production of grain, the price of grain will also be low—and thus attractive for both local consumption and export. Labor intensive
Labor intensity
Labor intensity is the relative proportion of labor used in a process. Its inverse is capital intensity....
goods on the other hand will be very expensive to produce since labor is scarce and its price is high. Therefore, the country is better off importing those goods.
Theoretical development of the model
The Ricardian model of comparative advantageComparative advantage
In economics, the law of comparative advantage says that two countries will both gain from trade if, in the absence of trade, they have different relative costs for producing the same goods...
has trade ultimately motivated by differences in labour productivity using different technologies. Heckscher and Ohlin didn't require production technology to vary between countries, so (in the interests of simplicity) the H-O model has identical production technology everywhere. Ricardo considered a single factor of production (labour) and would not have been able to produce comparative advantage without technological differences between countries (all nations would become autarkic at various stages of development, with no reason to trade with each other). The H-O model removed technology variations but introduced variable capital endowments, recreating endogenous
Endogenous
Endogenous substances are those that originate from within an organism, tissue, or cell. Endogenous retroviruses are caused by ancient infections of germ cells in humans, mammals and other vertebrates...
ly the inter-country variation of labour productivity that Ricardo had imposed exogenous
Exogenous
Exogenous refers to an action or object coming from outside a system. It is the opposite of endogenous, something generated from within the system....
ly. With international variations in the capital endowment (i.e. infrastructure
Infrastructure
Infrastructure is basic physical and organizational structures needed for the operation of a society or enterprise, or the services and facilities necessary for an economy to function...
) and goods requiring different factor proportions, Ricardo's comparative advantage emerges as a profit-maximizing solution of capitalist's choices from within the model's equations. (The decision capital owners are faced with is between investments in differing production technologies: The H-O model assumes capital is privately held.)
Original publication
Bertil OhlinBertil Ohlin
Bertil Gotthard Ohlin was a Swedish economist and politician. He was a professor of economics at the Stockholm School of Economics from 1929 to 1965. He was also leader of the People's Party, a social-liberal party which at the time was the largest party in opposition to the governing Social...
published the book which first explained the theory in 1933. Although he wrote the book alone, Heckscher was credited as co-developer of the model, because of his earlier work on the problem, and because many of the ideas in the final model came from Ohlin's doctoral thesis, supervised by Heckscher.
Interregional and International Trade itself was verbose, rather than being pared down to the mathematical, and appealed because of its new insights.
The 2×2×2 model
The original H-O model assumed that the only difference between countries was the relative abundances of labor and capital. The original Heckscher–Ohlin model contained two countries, and had two commodities that could be produced. Since there are two (homogeneous) factors of production this model is sometimes called the "2×2×2 model".The model has variable factor proportions between countries: Highly developed countries have a comparatively high ratio of capital to labor in relation to developing countries. This makes the developed country capital-abundant relative to the developing nation, and the developing nation labor-abundant in relation to the developed country.
With this single difference, Ohlin was able to discuss the new mechanism of comparative advantage
Comparative advantage
In economics, the law of comparative advantage says that two countries will both gain from trade if, in the absence of trade, they have different relative costs for producing the same goods...
, using just two goods and two technologies to produce them. (One technology would be a capital intensive
Capital intensity
Capital intensity is the term in economics for the amount of fixed or real capital present in relation to other factors of production, especially labor...
industry, the other a labor intensive business - see "assumptions" below).
Extensions
The model has been extended since the 1930s by many economists. These developments did not change the fundamental role of variable factor proportions in driving international trade, but added to the model various real-world considerations (such as tariffTariff
A tariff may be either tax on imports or exports , or a list or schedule of prices for such things as rail service, bus routes, and electrical usage ....
s) in the hopes of increasing the model's predictive power, or as a mathematical way of discussing macroeconomic policy options.
Notable contributions came from Paul Samuelson
Paul Samuelson
Paul Anthony Samuelson was an American economist, and the first American to win the Nobel Memorial Prize in Economic Sciences. The Swedish Royal Academies stated, when awarding the prize, that he "has done more than any other contemporary economist to raise the level of scientific analysis in...
, Ronald Jones
Ronald W. Jones
Ronald Winthrop "Ron" Jones is an influential international trade economist and Xerox Professor of Economics at the University of Rochester. His recent highly acclaimed book Globalization and the Theory of Input Trade summarizes much of his past work and also discusses the recent market trend...
, and Jaroslav Vanek
Jaroslav Vanek
Jaroslav Vanek is an economist and Professor Emeritus of Cornell University known for his research on labour-managed firms , and also to the theory of international trade.-Career:...
, so that variations of the model are sometimes called the Heckscher-Ohlin-Samuelson model or the Heckscher-Ohlin-Vanek model in the neo-classical economics.
Assumptions of the theory
The original, 2x2x2 model was derived with restrictive assumptions, partly for the sake of mathematical simplicity. Some of these have been relaxed for the sake of development. These assumptions and developments are listed here.Both countries have identical production technology
This assumption means that producing the same output of either commodity could be done with the same level of capital and labour in either country. Actually, it would be inefficient to actually use the same balance in either country (because of the relative availability of either input factor) but, in principle this would be possible. Another way of saying this is that the per-capita productivityProductivity
Productivity is a measure of the efficiency of production. Productivity is a ratio of what is produced to what is required to produce it. Usually this ratio is in the form of an average, expressing the total output divided by the total input...
is the same in both countries in the same technology with identical amounts of capital.
Countries have natural advantages in the production of various commodities in relation to one another, so this is an 'unrealistic' simplification designed to highlight the effect of variable factors. (This meant that the original HO-model produced an alternative explanation for free trade to Ricardo's, rather than a complementary one). In reality, both effects may occur (differences in technology and factor abundances).
In addition to natural advantages in the production of one sort of output over another (wine vs. rice, say) the infrastructure, education, culture, and 'know-how' of countries differ so dramatically that the idea of identical technologies is a theoretical notion. Ohlin said that the HO-model was a long run model, and that the conditions of industrial production are "everywhere the same" in the long run.
Production output must have constant Return to Scale
Both of the countries in the simple HO model produced both commodities, and both technologies have constant returns to scale (CRS). (CRS production has twice the output if both capital and labour inputs are doubled, so the two production functions must be 'homogeneousHomogeneous function
In mathematics, a homogeneous function is a function with multiplicative scaling behaviour: if the argument is multiplied by a factor, then the result is multiplied by some power of this factor. More precisely, if is a function between two vector spaces over a field F, and k is an integer, then...
of degree 1').
These conditions are required to produce a mathematical equilibrium. With increasing returns to scale it would likely be more efficient for countries to specialize, but specialization is not possible with the Heckscher-Ohlin assumptions.
The technologies used to produce the two commodities differ
The CRS production functions must differ to make trade worthwhile in this model. For instance if the functions are Cobb-DouglasCobb-Douglas
In economics, the Cobb–Douglas functional form of production functions is widely used to represent the relationship of an output to inputs. Similar functions were originally used by Knut Wicksell , while the Cobb-Douglas form was developed and tested against statistical evidence by Charles Cobb and...
technologies the parameters applied to the inputs must vary. An example would be:
- Arable industry:
- Fishing industry:
Where A is the output in arable
Agronomy
Agronomy is the science and technology of producing and using plants for food, fuel, feed, fiber, and reclamation. Agronomy encompasses work in the areas of plant genetics, plant physiology, meteorology, and soil science. Agronomy is the application of a combination of sciences like biology,...
production, F is the output in fish production, and K, L are capital and labour in both cases.
In this example, the marginal return to an extra unit of capital is higher in the fishing industry, assuming units of F(ish) and A(rable) output have equal value. The more capital-abundant country may gain by developing its fishing fleet at the expense of its arable farms. Conversely, the workers available in the relatively labour-abundant country can be employed relatively more efficiently in arable farming.
Labor mobility within countries
Within countries, capital and labor can be reinvested and re-employed to produce different outputs. Like the comparative advantageComparative advantage
In economics, the law of comparative advantage says that two countries will both gain from trade if, in the absence of trade, they have different relative costs for producing the same goods...
argument of Ricardo, this is assumed to happen costlessly.
If the two production technologies are the arable industry and the fishing industry it is assumed that farmers can shift to work as fishermen with no cost, and vice versa.
Capital mobility within countries
It is further assumed that capital can shift easily into either technology, so that the industrial mix can change without adjustment costs between the two types of production.For instance, if the two industries are farming and fishing it is assumed that farms can be sold to pay for the construction of fishing boats with no transaction costs.
Capital immobility between countries
The basic Heckscher–Ohlin model depends upon the relative availability of capital and labour differing internationally, but if capital can be freely invested anywhere competitionCompetition
Competition is a contest between individuals, groups, animals, etc. for territory, a niche, or a location of resources. It arises whenever two and only two strive for a goal which cannot be shared. Competition occurs naturally between living organisms which co-exist in the same environment. For...
(for investment) will make relative abundances identical throughout the world. (Essentially, Free Trade
Free trade
Under a free trade policy, prices emerge from supply and demand, and are the sole determinant of resource allocation. 'Free' trade differs from other forms of trade policy where the allocation of goods and services among trading countries are determined by price strategies that may differ from...
in capital would provide a single worldwide investment pool.)
Differences in labour abundance would not produce a difference in relative factor abundance (in relation to mobile capital) because the labour/capital ratio would be identical everywhere. (A large country would receive twice as much investment as a small one, for instance, maximizing capitalist's return on investment
Return on investment
Return on investment is one way of considering profits in relation to capital invested. Return on assets , return on net assets , return on capital and return on invested capital are similar measures with variations on how “investment” is defined.Marketing not only influences net profits but also...
).
As capital controls are reduced, the modern world has begun to look a lot less like the world modelled by Heckscher and Ohlin. It has been argued that capital mobility undermines the case for Free Trade
Free trade
Under a free trade policy, prices emerge from supply and demand, and are the sole determinant of resource allocation. 'Free' trade differs from other forms of trade policy where the allocation of goods and services among trading countries are determined by price strategies that may differ from...
itself, see: Capital mobility and comparative advantage Free trade critique. Capital is mobile when:
- There are limited exchange controls
- Foreign Direct InvestmentForeign direct investmentForeign direct investment or foreign investment refers to the net inflows of investment to acquire a lasting management interest in an enterprise operating in an economy other than that of the investor.. It is the sum of equity capital,other long-term capital, and short-term capital as shown in...
(FDI) is permitted between countries, or foreigners are permitted to invest in the commercial operations of a country through a stockStockThe capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
or corporate bondCorporate bondA corporate bond is a bond issued by a corporation. It is a bond that a corporation issues to raise money in order to expand its business. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date...
market
Labour immobility between countries
Like capital, labor movements are not permitted in the Heckscher-Ohlin world, since this would drive an equalization of relative abundances of the two production factors, just as in the case of capital immobility above. This condition is more defensible as a description of the modern world than the assumption that capital is confined to a single country.Commodities have the same price everywhere
The 2x2x2 model originally placed no barriers to trade, had no tariffTariff
A tariff may be either tax on imports or exports , or a list or schedule of prices for such things as rail service, bus routes, and electrical usage ....
s, and no exchange controls (capital was immobile, but repatriation of foreign sales was costless). It was also free of transportation costs between the countries, or any other savings that would favour procuring a local supply.
If the two countries have separate currencies
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
, this does not affect the model in any way (Purchasing Power Parity
Purchasing power parity
In economics, purchasing power parity is a condition between countries where an amount of money has the same purchasing power in different countries. The prices of the goods between the countries would only reflect the exchange rates...
applies). Since there are no transaction costs or currency issues the law of one price
Law of one price
The law of one price is an economic law stated as: "In an efficient market, all identical goods must have only one price."-Intuition:The intuition for this law is that all sellers will flock to the highest prevailing price, and all buyers to the lowest current market price. In an efficient market...
applies to both commodities, and consumers in either country pay exactly the same price for either good.
In Ohlin's day this assumption was a fairly neutral simplification, but economic changes and econometric research since the 1950s have shown that the local prices of goods tend to be correlated with incomes when both are converted at money prices (although this is less true with traded commodities). See: Penn effect
Penn effect
The Penn effect is the economic finding associated with what became the Penn World Table that real income ratios between high and low income countries are systematically exaggerated by gross domestic product conversion at market exchange rates...
.
Perfect internal competition
Neither labour nor capital has the power to affect prices or factor rates by constraining supply; a state of perfect competitionPerfect competition
In economic theory, perfect competition describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. Because the conditions for perfect competition are strict, there are few if any perfectly competitive markets...
exists.
Conclusions of the model
The results of this work has been the formulation of certain named conclusions arising from the assumptions inherent in the model. These are known as:Heckscher–Ohlin theorem
The exports of a capital-abundant country will be from capital-intensive industries, and labour-abundant countries will import such goods, exporting labour intensive goods in return. Competitive pressures within the H–O model produce this prediction fairly straightforwardly. Conveniently, this is an easily testable hypothesis.Rybczynski theorem
When the amount of one factor of production increases, the production of the good which uses that particular factor of production intensively increases relative to the increase in the factor of production,(as the H-O model assumes perfect competition where price is equal to the costs of factors of production). This theorem is useful in explaining the effects of immigration, emigration and foreign capital investment. However, Rybczynski suggests that a fixed quantity of the two factors of production are required. This could be expanded to consider factor substitution, in which case the increase in production would be more than proportional.
Stolper–Samuelson theorem
Relative changes in output goods prices will drive the relative prices of the factors used to produce them. If the world price of capital-intensive goods increases, it will increase the relative rentalRenting
Renting is an agreement where a payment is made for the temporary use of a good, service or property owned by another. A gross lease is when the tenant pays a flat rental amount and the landlord pays for all property charges regularly incurred by the ownership from landowners...
rate as well as decreasing the relative wage
Wage
A wage is a compensation, usually financial, received by workers in exchange for their labor.Compensation in terms of wages is given to workers and compensation in terms of salary is given to employees...
rate (the return on capital as against the return to labour). Also if the price of labour intensive goods increases, it will increase the relative wage
Wage
A wage is a compensation, usually financial, received by workers in exchange for their labor.Compensation in terms of wages is given to workers and compensation in terms of salary is given to employees...
rate as well as decreasing the relative rental
Renting
Renting is an agreement where a payment is made for the temporary use of a good, service or property owned by another. A gross lease is when the tenant pays a flat rental amount and the landlord pays for all property charges regularly incurred by the ownership from landowners...
rate .
Factor–Price equalization theorem
Free and competitive trade will make factor prices converge along with traded goods prices. The FPE theorem is the most significant conclusion of the HO-model, but it is also the theorem which has found the least agreement with the economic evidence. Neither the rentRenting
Renting is an agreement where a payment is made for the temporary use of a good, service or property owned by another. A gross lease is when the tenant pays a flat rental amount and the landlord pays for all property charges regularly incurred by the ownership from landowners...
al return to capital, nor the wage
Wage
A wage is a compensation, usually financial, received by workers in exchange for their labor.Compensation in terms of wages is given to workers and compensation in terms of salary is given to employees...
rates seem to consistently converge between trading partners at different levels of development.
The implications of factor-proportion changes
The Stolper–Samuelson theorem concerns nominal rents and wages. The Magnification effect on prices considers the effect of output-goods price-changes on the real return to capital and labour. This is done by dividing the nominal rates with a price indexPrice index
A price index is a normalized average of prices for a given class of goods or services in a given region, during a given interval of time...
, but took thirty years to develop completely because of the theoretical complexity involved.
- The Magnification effect shows that trade liberalization will actually make the locally-scarce factor of production worse off (because increased trade makes the price index fall by less than the drop in returns to the scarce-factor induced by the Stolper–Samuelson theorem).
- The Magnification effect on production quantity-shifts induced by endowment changes (via the Rybczynski theorem) predicts a larger proportionate shift in output-quantity than in the corresponding endowment factor shift which induced it. This has implications to both labour and capital:
- Assuming fixed capital, population growth will dilute the scarcity of labour in relation to capital. If the population growth outpaces the growth in capital by 10% this may translate into a 20% shift in the balance of employment to the labour-intensive industries.
- In the modern world, moneyMoneyMoney is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...
tends to be much more mobile than labour, so import of capital to a country will almost certainly shift the relative factor-abundances in favour of capital. The magnification effect says that a 10% increase in national capital may lead to a redistribution of labour amounting to a fifth of the entire economy (towards capital-intensive, high-tech production). Notably, employment patterns in very poor countries can be dramatically affected by a small amount of FDIForeign direct investmentForeign direct investment or foreign investment refers to the net inflows of investment to acquire a lasting management interest in an enterprise operating in an economy other than that of the investor.. It is the sum of equity capital,other long-term capital, and short-term capital as shown in...
, in this model. (See also: Dutch diseaseDutch diseaseIn economics, the Dutch disease is a concept that purportedly explains the apparent relationship between the increase in exploitation of natural resources and a decline in the manufacturing sector...
.)
Econometric testing of H–O model theorems
Heckscher and Ohlin considered the Factor-Price Equalization theorem an econometric success because the large volume of international trade in the late 19th and early 20th centuries coincided with the convergence of commodity and factor prices worldwide.Modern econometric estimates have shown the model to perform poorly, however, and adjustments have been suggested, most importantly the assumption that technology is not the same everywhere. (This change would mean abandoning the pure H–O model.)
The Leontief paradox
In 1954, an econometric test by Wassily W. Leontief of the H–O model found that the US, despite having a relative abundance of capital, tended to export labor intensive goods and import capital intensive goods. This problem became known as the Leontief paradoxLeontief paradox
Leontief's paradox in economics is that the country with the world's highest capital-per worker has a lower capital/labor ratio in exports than in imports....
. Alternative trade models and various explanations for the paradox have emerged as a result of the paradox. One such trade model, the Linder hypothesis
Linder hypothesis
The Linder hypothesis is a economics conjecture about international trade patterns: The more similar the demand structures of countries, the more they will trade with one another...
, suggests that goods are traded based on similar demand rather than differences in supply side factors (i.e.. H–O's factor endowments).
The Vanek formula
Various attempts in the 1960s and 1970s to "solve" the Leontief paradox and save the Heckscher-Ohlin Theory failed. From the 1980s a new series of statistical tests had been tried. The new tests depended on the Vanek's formula. It takes a simple form- Fc = Vc − sc V
where Fc is the net trade of factor service vector for country c, Vc the factor endowment vector for country c, and sc the country c's share of the world consumption and V the world total endowment vector of factors. For many countries and many factors, it is possible to estimate the left hand sides and right hand sides independently. To put it another way, the right hand side tells the direction of factor service trade. Thus it is possible to ask how this system of equations holds. The results obtained by Bowen, Leamer and Sveiskaus (1987) was disastrous. They examined the cases of 12 factors and 27 countries for the year 1967. They found that the both sides of the equations had the same sign only for 61 percent out of 324 cases. For the year 1983, the result was more disastrous. Both sides had the same sign only for 148 cases out of 297 cases (or the rate of correct predictions was 49.8%). The results of Bowen, Leamer and Sveiskaus (1987) mean that the Hecksher–Ohlin–Vanek theory has no predictive power concerning the directions of trade.
Criticism against the Heckscher–Ohlin model
Although H-O model is normally thought to be basic for the international trade theory, there are many points of criticism against the model.Poor predictive power
The original Heckscher–Ohlin model and extended model such as the Vanek model performs poorly, as it is shown in the section "Econometric testing of H-O model theorems". Daniel Trefler and Susan Chun Zhu summarises their paper that "It is hard to believe that factor endowments theory [editor's note: in other words, Heckscher–Ohlin–Vanek Model] could offer an adequate explanation of international trade patterns."A common understanding exists that in the national level HOV model fits well. In fact, Davis and others found that HOV model fitted extremely well with the regional data of Japan. Even when the HOV formula fits well, it does not mean that Heckscher–Ohlin theory is valid. Indeed, Heckscher–Ohlin theory claims that the state of factor endowments of each country (or each region) determines the production of each country (respectively of each region) but Bernstein and Weinstein found that the factor endowments have little predictive power. The factor-endowments-driven model (FED model) has errors much greater than HOV model.
Factor equalization theorem
The factor equalization theorem (FET) applies only for most advanced countries. The average wage in Japan was once as big as 70 times the wage in Vietnam. These wage discrepancies are not normally in the scope of the H-O model analysis.Heckscher–Ohlin theory is badly adapted to the analyze South-North trade problems. The assumptions of HO are unrealistic with respect to North-South trade. Income differences between North and South is the concern that third world cares most. The factor price equalization theorem has not shown a sign of realization, even for a long time lag of a half century.
Identical production function
The standard Heckscher–Ohlin model assumes that the production functions are identical for all countries concerned. This means that all countries are in the same level of production and have the same technology. This is highly unrealistic. Technological gap between developed and developing countries is the main concern for the development of poor countries. The standard Heckscher–Ohlin model ignores all these vital factors when one wants to consider development of less developed countries in the international context. Even between developed countries, technology differs from industry to industry and firm to firm base. Indeed this is the very basis of the competition between firms, inside the country and across the country. See the New Trade Theory in this article below.Capital as endowment
In the modern production system, machines and apparatuses play an important role. What is named capital is nothing other than these machines and apparatuses, together with materials and intermediate products which will be consumed in the production process. Capital is the most important of factors, or one should say as important as labor. By the help of machines and apparatuses, the human being got a tremendous production capability. These machines, apparatuses and tools are classified as capital, or more precisely as durable capital, for one uses these items for many years. Their quantity is not changed at once. But the capital is not an endowment given by the nature. It is composed of goods manufactured in the production and often imported from foreign countries. In this sense, capital is internationally mobile and the result of past economic activity. The concept of capital as natural endowment distorts the real role of capital. Capital is a production power accumulated by the past investment.Homogeneous capital
Capital goods take different forms. It may take the form of a machine-tool such as lathe, the form of a transfer-machine, which you can see under the belt-conveyors. It may take the form of oil or iron core. Despite these facts, capital in the Hechscher–Ohlin Model is assumed as homogeneous and transferable to any form if necessary. This assumption is not only far from the reality, but also it includes logical flaw. Capital has a measure, just like anything has weight. How can an amount of various goods be measured?Usually by a system of prices. But prices are dependent of profit rate. In the Heckscher–Ohlin model, the rate of profit is determined according to how abundant capital is. If capital is scarce, it has a high rate of profit. If it is abundant, the profit rate is low. Here is a logical circle. Before the profit rate is determined, the amount of capital is not measured. This logical difficulty was the subject of academic controversy which took place many years ago. In fact, this is sometimes named Cambridge Capital Controversies
Cambridge capital controversy
The Cambridge capital controversy – sometimes simply called "the capital controversy" – refers to a theoretical and mathematical debate during the 1960s among economists concerning the nature and role of capital goods and the critique of the dominant neoclassical vision of aggregate...
. The conclusion of the controversies was that the concept of homogeneous capital was untenable. Heckscher–Ohlin theorists ignore all these stories without providing any explanation how capital is measured theoretically.
No unemploymnent
Unemployment is the vital question in any trade conflict. Heckscher–Ohlin theory excludes unemployment by the very formulation of the model, in which all factors (including labour) are employed in the production.No room for firms
Standard Heckscher–Ohlin theory assumes the same production function for all countries. This implies that all firms are identical. The theoretical consequence is that there is no room for firms in the HO model. By contrast, the New Trade TheoryNew Trade Theory
New Trade Theory is a collection of economic models in international trade which focuses on the role of increasing returns to scale and network effects, which were developed in the late 1970s and early 1980s....
emphasizes that firms are heterogeneous.
Political background for HO-Model
From the middle of the 19th century to 1930s, giant flow of immigration took place from Europe to North America. It is estimated that more than 60 million people crossed the Atlantic Ocean. Some politicians worried if these immigrants may cause various troubles (including cultural conflicts). For those politicians HO-theory provided a good reason “in support of both restrictions on labor migration and free trade in goods.”New Trade Theory
New Trade theorists challenge the assumption of diminishing returns to scale, and some argue that using protectionist measures to build up a huge industrial base in certain industries would then allow those sectors to dominate the world market, via a network effectNetwork effect
In economics and business, a network effect is the effect that one user of a good or service has on the value of that product to other people. When network effect is present, the value of a product or service is dependent on the number of others using it.The classic example is the telephone...
.
See also Intra-industry trade
Intra-industry trade
Intra-industry trade refers to the exchange of products belonging to the same industry. The term is usually applied to international trade, where the same kinds of goods or services are both imported and exported.-Examples:...
.
New New Trade Theory
New New Trade Theory analyses individual enterprises and plants in an international competitive situation. The classical trade theory (i.e. the Heckscher–Ohlin model) has no enterprises in mind. The New trade theory treats enterprises in an industry as identical entities. New New Trade Theory gives focus on the diversity of enterprises. It is a stylized fact that there are enterprises which engage in export and ones which do not. Some enterprises invest directly in the foreign country in order to produce and sell in that country. Some other enterprises engage only in export. Why does this kind of differences occur? New New Trade Theory tries to find out the reasons of these well observed facts.Gravity model of trade
The gravity model of international trade predicts bilateral trade flows based on the economic sizes of two nations, and the distance between them.Ricardo–Sraffa trade theory
See also: The Ricardian Theory of International TradeRicardian theory is now extended in a general form which includes not only labor but also inputs of materials and intermediate goods. In this sense, it is much general and plausible than the Heckscher–Ohlin model and escapes from the logical problems such as capital as endowments, which is in reality produced goods.
As the theory permits different production processes to coexist in an industry of a country, the Ricardo–Sraffa theory can give a theoretical bases for the New Trade Theory.
See also
- International factor movementsInternational factor movementsIn international economics, international factor movements are movements of labor, capital, and other factors of production between countries. International factor movements occur in three ways: immigration/emigration, capital transfers through international borrowing and lending, and foreign...
- List of international trade topics
- International tradeInternational tradeInternational trade is the exchange of capital, goods, and services across international borders or territories. In most countries, such trade represents a significant share of gross domestic product...
- Free tradeFree tradeUnder a free trade policy, prices emerge from supply and demand, and are the sole determinant of resource allocation. 'Free' trade differs from other forms of trade policy where the allocation of goods and services among trading countries are determined by price strategies that may differ from...
- Comparative advantageComparative advantageIn economics, the law of comparative advantage says that two countries will both gain from trade if, in the absence of trade, they have different relative costs for producing the same goods...
- an international trade model with varying technology between countries - Balassa–Samuelson effect - an international trade model with traded and non-traded economic sectors
- Linder hypothesisLinder hypothesisThe Linder hypothesis is a economics conjecture about international trade patterns: The more similar the demand structures of countries, the more they will trade with one another...
- Gravity model of tradeGravity model of tradeThe gravity model of trade in international economics, similar to other gravity models in social science, predicts bilateral trade flows based on the economic sizes of and distance between two units. The model was first used by Tinbergen in 1962...
- Intra-industry tradeIntra-industry tradeIntra-industry trade refers to the exchange of products belonging to the same industry. The term is usually applied to international trade, where the same kinds of goods or services are both imported and exported.-Examples:...
External links
- A precisely defined two-goods H-O model
- The Heckscher-Ohlin Model Between 1400 and 2000 An econometric analysis of factor prices, commodity prices, and endowments in intercontinental trade by NBER in 1999. It finds that 19th century trade patterns and economies can be successfully modelled within an H-O framework.
- Test yourself on the H-O model