Essay on the Heckscher-Ohlin Theorem of International Trade

It may be pointed out at the outset that, the Heckscher- Ohlin theory does not invalidate the classical theory of comparative costs, but rather powerfully supplement it, since it also accepts comparative advantage as the cause of international trade. However, the new theory succeeds where the classical theory fails in answering the question: why, after all, is there a difference in comparative costs among countries? The classical two-country, two-commodity and one-factor model was incapable of furnishing a satisfactory answer to this question.

The answer is given by Eli Heckscher and Bertil Ohlin with an exposition of territorial specialisation and trade in terms of the modern value theory, in place of the traditional labour theory of value of comparative costs.

Thus, the major contribution of Heckscher-Ohlin approach is to inquire more fundamentally into the ultimate basis of trade. Regarding the cause of trade, however, Heckscher- Ohlin’s explanation agrees with that of the classical school. But Heckscher-Ohlin theorem primarily seeks to explain what brings about the market difference in the comparative cost ratios as between prospective trading countries.

According to Ohlin, international trade is a special case of inter-regional trade. There are no fundamental differences but only quantitative differences between inter-regional and international trade.

Ohlin states that different regions have different factor endowments and the production of different goods requires different factor inputs. That is to say, the production function differs from commodity to commodity. Proportion of factors’ combination thus, varies from goods to goods. Some production functions, therefore, contain relatively greater proportion of labour and less o capital; whereas, some may contain more of capital and less of labour.

Thus, each region is best equipped to produce the goods that require a large proportion of the factors relatively abundant there; it is least fit to produce goods which require a larger proportion of factors but which are available to it in small quantities or not at all. Thus, the ability of different regions to produce different goods will differ because of difference in factor endowments.

According to Ohlin, this variation in productive factors is the explicit cause of inter-regional specialisation and trade (international trade), just as varying individual ability is the cause of exchange between individuals (when there is individual specialisation or division of labour).

In fact, it was Heckscher who originated the idea that, though, comparative costs difference is the basis of international trade, the root cause is the condition which produces this difference.

As a matter of fact, the difference in comparative costs advantage occurs because of (i) the difference in relative scarcity (and so relative price) of factors of production in the two countries, and (ii) the input of different factor proportions required in the production function of different commodities. The same thought was further elaborated by Prof. Ohlin.

According to him also, the immediate cause of international trade is differences in commodity prices, and differences in factor endowments cause factor prices to differ. (Since factor prices are the ultimate costs of production, costs and thus, commodity prices will differ in different countries).

That is to say, the difference in factor intensities in the production functions of commodities together with equal differences in relative factor of endowments of the countries causes the comparative costs differences in goods produced internationally, which set the base of international trade.

It is an undisputed fact that regions are very differently endowed with facilities for the production of various goods as they are differently supplied with productive factors. In region A the supply of capital may be abundant but labour may be scarce. In region B the reverse may be the case.

Thus, in region/i machines may be cheaper but wheat may be costlier. This will be so if capital is relatively cheaper due to its abundance, while labour is costlier due to its relative scarcity and a greater proportion of capital is needed for producing machines. Similarly, in region B because capita! is scarce, machines will be costlier, while wheat will be cheaper, labour being cheap and abundant.

Thus, a different set of prices will operate in both the regions for different goods, depending on relative scarcity and thus, relative factor prices. It appears, therefore, that region A will possess a comparative cost advantage in the production of goods which employ more of the factors that are relatively abundant (and so cheap) in it. Similarly, region B will possess a comparative cost advantage in the production of goods which employ more of the factors that are relatively abundant in it.

It thus, follows that region A will specialise in the production and export of goods (such as machines) which employ more of its relatively abundant and less to its relatively scarce factors and will import these goods (such as wheat) which call for factors in the reverse proportion. The same will hold good in region B also.

This means that, indirectly factors in abundant supply are exported (in the form of goods produced by them) and factors in scant supply are imported by a country.

Ohlin, thus, laid down that the first condition of trade is that the same goods can be produced more cheaply in one region than in another. Therefore, the immediate cause of inter-regional trade is always that, goods can be bought cheaper from outside in terms of money value than they can be produced at home.

Ohlin, thus, goes ahead with the classical doctrine by stating that it is not the difference in the original costs of production of commodity that leads to specialisation (hence, international trade), but that it is the difference in the final prices of commodity which leads to specialisation and trade. It goes without saying that the prices of commodities are determined not only by the costs of production but also by the demand for them. Unlike the classical theory thus, Ohlin’s theory is not one-sided. It considers both demand and supply aspects.

It follows that the relative price differences between two regions arise because of differences in the demand and supply conditions in both the regions. The relative commodity prices will, however, be alike in the two regions under the following conditions:

(i) When demand and supply conditions for goods in both the regions are identical. It thus, follows that wants, preferences, tastes, habits, incomes and other variants influencing demand position and pattern have unique similarity between two regions. Likewise, factor endowments between two regions are also alike.

(ii) When demand and supply of factors of production are exactly balanced. Thus, any difference in the factors’ supply is counterbalanced by a compensating difference in their demand.

These conditions are hardly fulfilled in the real world. Hence, differences in relative factor supplies as well as in demand persist, leading to differences in relative factor prices and hence, in relative commodity prices between two regions. It should be noted that, the differences in commodity prices arise as a result of differences in the supply of factors of production in two regions.

Thus, according to Ohlin, varying factor supplies are the main cause for the inequalities in costs of production and commodity prices that lead to trade between two regions. And such trade implies that commodities containing a large proportion of scant and dear factors are imported, while those containing, a large proportion of abundant and cheaper factors are exported.

In support of his factor-proportions theory of international trade, Ohlin gives illustration of trade between Australia and England. Australia trades wheat and wood against manufactures of England, because wheat and wood require much land of grades as is found in large quantities in the Australian region, whereas, manufactures require large quantities of labour and capital like coal and iron, which are scantily available in Australia.

Things are contrary with England in this case. Consequently, there has been a relative price difference of these commodities in both the countries.

Thus, trade has emerged. Evidently, when Australia exports wheat, wool, etc., it is indirectly exporting factors in abundant supply there, and when its imports manufactures, it is indirectly importing factors in scant supply. It appears thus, that international trade is an economic solution of immobility of disproportionate factors between different countries.

It should be noted that according to Ohlin’s theory relative price differences lead to absolute price differences when a rate of exchange is settled. It is only when an exchange rate between two currencies has been established that one can ascertain whether, a factor is cheaper or dearer in region^ than in region B. We may illustrate this point as in Table 5.1 below: From the table we find that, there are four factors P, Q, R, and S in both the regions (A and B). Columns (2) and (3) denote factor prices in B and A in their respective currencies, Rupee and Dollars.

It is clear that in both the regions P is cheapest, while S is dearest factor. However, merely looking at columns (2) and (3), it is not possible to detect which of the factors are relatively cheap or dear in the two regions. For this we must find out the absolute price difference between the two regions. This can be done by translating the factor prices of one region in terms of the other region, in view of the prevailing rate of exchange.

Suppose, the rate of exchange is $1 = Rs. 20; then we can express the factor prices in region A in terms of B’s currency, as in column (4). Comparing columns (2) and (4), we find that factors P and Q are relatively cheaper in region B. But if we assume that the rate of exchange is $1 = Rs. 30, i.e., A’s currency commands better value in the world market, then we find from column (5) and comparing it with column (2), that only P seems to be cheaper in region A while the rest of the factors are cheaper in region B.

Thus, in the first case, region B will concentrate on the production of those goods which employ large amount of R and S factors, while region A will produce goods requiring more use of factors P and Q. In the second case, however, region A can produce relatively cheaply only those goods which require more employment of factor P, while region B can produce all other goods containing factors Q, R and S more cheaply.

It follows that each region will specialise in and export “cheap factor bounded commodities” and import “dear factor bounded commodities.” Thus, absolute price differences known from the exchange rates indicate which of the factors are cheap and which dear in each region and consequently in what commodities each region will specialise. It should be remembered that the rate of exchange does not determine relative cheapness or dearness (or abundance or scarcity) of factors between regions. It only indicates a fact.

Ohlin further points out that the rate of exchange and value of inter-regional or international trade are determined by the conditions of reciprocal demand, i.e., by all the basic elements of pricing in all regions.