What are the Assumptions and Elucidation of the Heckscher-Ohlin Theorem?

The Heckscher-Ohlin’s factor proportions analysis exposing the basis of international trade, as stated above, rests on a number of explicit and implicit assumptions which are as follows:

1. A “double” model system is considered, in which there are two countries, two commodities and two factors of production, labour and capital.

2. The relative endowments of the two factors (labour and capital) are disproportionate in the two countries. Quantitatively, thus, factor supplies are differently fixed. But qualitatively each factor is homogeneous in both countries.

3. Factors of production are perfectly mobile within their respective countries but immobile between countries.

4. There is perfect competition in all markets – factor as well as commodity markets – and full employment of resources in both the countries.

5. The production functions are different for different goods but the same for each good in two countries.

6. The production functions for different goods are such as can be distinguished by intensity of factor inputs. Thus, goods can be classified in terms of their factor intensity as labour- intensive and capital-intensive goods.

7. In both countries, techniques of producing identical goods are the same. Thus, the production functions are homogeneous in two countries, implying that if one good is relatively labour-intensive in one country, it is relatively labour-intensive in the other country too, irrespective of the relative factor prices (the price of labour relative to the price of capital) in the country.

8. Each production function is subjected to the constant returns to scale, i.e., a given proportion of factor input results in the same proportionate output.

9. Trade between two countries is free and costless. There are no tariffs or other barriers and no transport or similar costs.

10. Consumer preferences, thus demand for goods, are identical in both the countries.

All such assumptions have been made in order to specify but at the same time, minimise the analytical differences between the two countries.

Given these assumptions, Ohlin’s thesis contends that, a country exports good which use relatively a greater proportion of its relatively abundant thus, cheap factors. It is implied that trade occurs because there are differences in relative commodity prices caused by differences in relative factor prices (thus a comparative advantage) as a result of differences in the factor endowments between the countries.

The “relative factor abundance” in the thesis has two conceptions: (i) the price criterion of relative factor abundance; and (ii) the physical criterion of relative factor abundance.

According to the price criterion, a country having capital relatively cheap and labour relatively dear is regarded as relatively capital-abundant, irrespective of its ratio of total quantities of capital to labour in comparison with the other country. In symbolic terms, when:

Country A is relatively capital-abundant. (Here, P stands for factor price and K for capital, L for labour, A and B for the two respective countries.)

Viewing the physical criteria, strictly implying relative factor endowments in physical quantities, a country is relatively capital-abundant only if it possesses a greater proportion of capital to labour as compared to the other country. To put it symbolically, then:

Country A is relatively capital abundant, whether or not the ratio of the prices of capital to labour is lower than country B.

Using the price criterion of relative factor abundance, Ohlin’s conclusion can be traced immediately from the assumptions made above, without consideration of demand conditions or factor proportions.

But if the physical criterion is viewed, demand conditions are to be considered in order to establish the theorem. Ohlin, it seems, chooses the former criterion of determining the relative factor abundance and relative cheaper ness interchangeably; but, he also lays down that, the difference in factor prices is due to the difference in relative endowments of the factors between countries.

He, thus, asserts that once the relative physical quantities of each productive factor endowed in both the countries are known, the relative factor-price structure for each country can be easily inferred. Evidently, a country possessing relatively abundant capital will have a factor price structure such that capital will be more cheap compared to labour (relatively scarce factor). It follows, thus, that a relatively cheap factor in a country implies that it is relatively abundant factor.

Hence, considering physical quantities and scarcities rather than economic scarcities, Ohlin assumes that, the supply aspect has greater significance than demand in determining the relative factor prices in a country.

Ohlin then stresses the point that the factor-price structure will be different in two countries when the factor endowments are in differing proportions. Comparative advantages thus, arise when the capital-abundant country (A) exports capital-intensive goods and imports labour-intensive goods and the labour-abundant country (B) exports labour-intensive goods and imports capital-intensive

in two countries and commodity factor intensities are also the same, there will be no comparative.

Price differences there is no comparative cost difference; hence, no Theoretical basis for international trade. In examining the effect of trade, Ohlin has drawn an important corollary from his factor-proportions analysis known as “the factor-price equalisation theorem.”;

The basic contention of Heckscher-Ohlin theorem, as has been seen in the previous sections, is that: factor-intensity difference in the production functions of two goods, in conjunction with the differing factor endowments of the two countries, accounts for the international difference in comparative costs, causing differences in the relative commodity prices.

According to Ohlin, thus, trade takes place when relative differences (ignoring transport costs) have been eliminated. In the absence of transport costs or other impediments (such as tariffs) to trade, the most immediate effect of international trade is that it will equalise relative commodity prices in all regions.

The commodity price equalisation tendency is inherent in international trade, because the opening of free trade between two countries tend to eliminate the pre-trade differences in the comparative costs. As the volume of trade increases, comparative costs difference between the two countries diminishes, so that, differences in relative prices become small.

This increase in trade stops at the point when the comparative costs differences no longer obtain; hence, the relative prices of goods are the same in both the countries. The free trade equilibrium in Ohlin’s theory is, therefore, at a point where comparative costs differences disappear and the relative commodity prices in both the countries are equal.

Apparently, the relative commodity prices would become equal when the relative factor prices are equalised. Thus, the most significant consequence of free trade is that it tends to bring about equalisation of factor prices.

The theorem of factor-price equalisation thus contends that fundamentally, international trade in commodities acts as a substitute for the mobility of factors between commodities. When the factors of production are completely immobile internationally, but goods are freely exchanged between countries, then the prices of these factors tend to become equal (both relatively and absolutely) in the countries concerned.

This theorem becomes apparent from a very commonsense reasoning, too. Suppose, factors of production are perfectly mobile between countries. Then, the differences in the price of a factor in two countries will create forces causing that factor to move from the low-return country to the high-return country.

Such movement implies that the factor will become less abundant in the low- return country and less scarce in the high-return country, so that, return or price of the factor tends to rise in the former and fall in the latter country.

Thus, the factor movement will continue till its price are equalised in both the countries. It means, the prices of factor internationally will tend to be equal as a result of international mobility. Perfect international mobility of factors thus, leads to factor- price equalisation.

In specific terms, the tendency of factor price equalisation as a result of inter

Ohlin realising this tendency argues that in practice when factors lack international mobility in the physical sense, the same is implied in the exchange of goods produced by these factors.

When a country exports capital-intensive goods in exchange, it indirectly exports its abundant/cheap capital and imports scarce/dear labour. Under trade, thus, the factors concerned move in the form of goods. International trade in commodities as such acts as a substitute for the mobility of factors between countries.

It, therefore, follows that free commodity trade between countries has the effect similar to that of free international mobility of factors of production, i.e., a tendency to make factor prices equal internationally.

national trade follows from the fact that export will raise the demand and thus the price of the abundant and cheap factors, and import will reduce the demand and thus, the price of the scarce and expensive factors.

To elucidate this point, let us take a very simple case of two regions A and B and two factors, labour and capital. Let us assume that capital is relatively abundant and cheap in region A, while labour is relatively abundant and cheap in region B. Thus, region B with an abundant supply of labour but a scant supply of capital finds it advantageous to import goods requiring much capital, since they can be more cheaply produced ‘abroad’ in region A, and to export goods embodying much labour. In region B, industries using great quantities of capital will be reduced or stopped; hence, the demand for capital will decrease in this region.

This price of scarce factor will fall (its supply being the same with the reduced demand). On the other hand, in this region, industries that require large amount of labour will expand, so that, the demand for labour will increase. With the increasing demand, this abundant factor-labour-will now become relatively scarce.

Thus, its price will rise. In short, as a result of international trade, the scarcity of capital is reduced and that of labour is increased; hence the price of the former will fall and that of the latter will rise in region B. Thus, the relative factor price – changes in country B, so that capital will now be substituted for labour in both the industries, labour-intensive and capital-intensive.

In region B, the opening up of trade, as such, tends to reduce the disparity between the returns to the factors of production that existed in the pre-trade situation, when trade results in cheapening of the relatively expensive-scarce factor and an increase in the returns to the relatively cheap-abundant factor. [For with a relative rises the capital-labour ratio

The marginal product of labour rises, as does the return to labour, the relatively

Cheap factor. Correspondingly, the return to capital, the relatively dear factor, falls.]

Likewise, region A, which has plenty of capital but scarce labour, will import goods requiring much of labour and export goods embodying much of capital. Hence, its concentration on industries using much capital means greater relative scarcity of capital and less relative scarcity of labour. Evidently, in both the regions the factor that is relatively abundant becomes more in demand as a result of territorial specialisation and fetches a higher price than before in international trade, whereas demands for the scarce factor falls and it yields, relatively a lower reward (price) than before. This reasoning holds good for a greater number of factors also.

As Ohlin elucidated the point, let us assume that some of the factors (x1 x2 . . . x1) are relatively abundant in A, thus being cheaper there than in region B. Similarly, rest of the factors (x1 . .. xn) are relatively scarce and dearer in A but cheaper in B. After opening up of trade, demand for factors cheaper in region A than in B increases, consequently their prices rise in A but these very) factors’ demand in region B contracts and their price decrease. Similarly, factors that are relatively1 dearer in A than in B become less in demand, so that, their prices fall there, while the reverse happens in the case of the same factors in B.

As a matter of fact, the relative scarcity of the productive factors is reduced in both the regions on account of international trade, which leads to equalisation of factor prices, implying that the real j factor prices must exactly be the same in both the countries.