Heckscher-Ohlin Theorem, Essay Example

“Why cannot the Heckscher-Ohlin theorem explain the presence of Intra-Industry trade?”

In the beginning of the 20^th century, two Swedish economists, Bertil Ohlin and Eli Heckscher created the international trade theory, factor proportions theory. Their theory stressed that countries should produce and export goods that are required abundant resources, and import the goods that are considered resources that are in short supply. In other words, the country is abundant in capital will export the capital intensive good, and the country that is more labor abundant will export the labor intensive good. The countries generally referred to as foreign and home, with the goods cloth and foods, and two production factors labor and land. The countries will both export the goods that produces the better goods than the other. The Swedish doctors laid the groundwork for the trade theory by, “focusing on the relationships between the composition of countries’’ factor endowments and commodity trade patterns as well as the consequences of free trade for the functional distribution of income within countries” (Jones, n.d).

The concepts of Hecksher-Ohlin Theorem are dependent on the relative factor of intensity and abundance in the small dimensional context that the theory was developed. Each country is engaged in free trade where they both produce the same commodities in a competitive setting, which is supported by the returns to scale the technology that is shared from each country. The theory pushes for countries to specialize production and export using the most abundant and produced more efficiently (cheap) good. “Specialization in production and trade between countries generates, according to this theory, a higher standard-of-living for the countries involved “(Nobel Prize, 2006). According to Ohlin trade arises due to the differences in the prices of goods in each countries. The differences in prices is due to the difference in factor or cost prices due to endowments such as capital and labor in each country. This theory insinuates that trade occurs because each country has different capital and labor factors. Not only are there differences in labor productivity but also, labor skills, physical capital, and other factors of production in each country.

Heckscher-Ohlin Theorem explains the approach to international trade based on a few assumptions. Heckscher-Ohlin Theorem assumes that there are only two countries involved in the trade, and that each country has two factors, labor and capital. The theorem assumes that the two countries are in perfect competition in the factor or commodities market, where all production functions are homogeneous of their production to constant returns to scale. Each country has the same technology and the same consumer tastes, and both capital and labor is constant and varies in each country. (Kemp, 2008). Capital and labor factors are freely mobile within each country but are immobile between the countries, and that each country differs in factor supply. The theorem assumes that production functions remain the same in each country, where in one country it changes, in the other country it changes. In each country there is full employment of the resources, and identical demand in each country. The workers are paid a competitive wage and the land owners are paid competitive rent. There are no trade restrictions, such as non-tariffs and tariffs for each country, and there are no transporation costs. (Kemp, 2008) Trade between countries increases the income. However Heckscher-Ohlin Theorem assumed that there are some individuals that do not benefit. “Even though countries as a whole benefit from specialization and international trade, all groups in society, workers and capitalists, do not gain according to the Heckscher-Ohlin theory”(Nobel Prize, 2006). The entire countries however benefit because the gain in workers will be bigger than the capital owners loss.

Like the Ricardian Model that Heckscher-Ohlin is inspired by predicts that there is a convergence of relative trade with prices. With trade the relative price raised in the labor abundant country and falls in the labor scarce country. The comparative advantage of production in the economy of the country will export the goods that intensive using abundant factors of production. The differences between the two model theorems are that the Ricardian model places emphasis on the technological differeces but doesn’t include the endowment (capital and labor) differences. The Heckscher-Ohlin model theorem focuses on the endowment differences but doesn’t account for the technological differences.

There are number of criticisms aimed at why the assumptions made by Heckscher and Ohlin are not proven. While Heckscher-Ohlin theorem assumes that both countries will have the same production technology were they produce the same output of their commodity on the same level of capital in the other country, it is actually inefficient. “The potential stumbling block is the fact that even though countries share the same technology, the commodity that is produced by relatively labor-intensive techniques at home may be produced by relatively capital-intensive techniques abroad”(Jones, n.d). The lists of unrealistic assumptions continues as the theorem assumes there is no difference qualitatively of factors in production, constant return of scale, and production function. The theorem is also restrictive pinpointing the trade theorem based on two factors, countries, and commodities. The theorem is one sides where supply plays a key role over demand in determinant of factor prices, unlike if demand was the key factor than the capital abundant country would export the labor intensive good as the price would be high due to the high demand for the capital. The Theorem ignores consumer demand influences commodity prices, and isn’t based on an equilibrium analysis. As stated earlier like the Ricardian Theory they both don’t account for a central part of trade in Heckscher–Ohlin Theorem’s case it doesn’t account for change in the economy or the production function, which is static in nature. Other economist criticize the theorem based on the statement of factor prices determining the costs of the commodity prices, but it is actually reverse where commodity prices determine the factor prices. The problem lies that/ the theorem rests upon both a concept of factor abundance related to pre-trade factor prices ratios and special shapes for the production functions”(Jones, 1957). If the factors between the countries were to change than the Theorem would be useless, and would not hold between most countries.

The limitations of Heckscher-Ohlin Theorem also extend to the notion of Intra-Industry Trade. Intra-Industry trade can include trades of food and bevarages, technology, minerals, and automobiles. Countries exchange similar goods within the same industry, for a comparative or competitive advantage. Partially explained in international trade theories such as Heckscher-Ohlin Theorem, the reasons that countries import and export goods of the same industry at the same time is for a comparative advantage. However as explained earlier, the theorem falls shorts through its many unrealistic assumptions that countries with the same factors or endowments would not produce or trade goods domestically. (Appleyard, Field Jr, Cobb, 2010) Intra-Industry trade is generally referred to as international trade classified as horizontal trade that has similar product but different varieties, and vertical trade where the goods differ in quality and price. Intra-Industry theory allows for the economies of countries to specialize in a limited amount of goods and take advantage of its increasing returns, but also increase the variety for the consumers. Intra-Industry theory is only beneficial to countries that produce efficiently in each stage of the value chain. Intra-Industry trade is changing as the flow and size is determent on subsidies that give preferential market access, and create unfair competition from undervalued exchange rates. Poor logistics and the infrastructure pose a problem, as well as political interference that creates extensive documentation, and unofficial high payments that increase the cost of business. The lack of compliance in quality upgrade to international trade standards creates trouble within the intra-industry.

The misunderstanding when explaining Intra-Industry Trade is the linking of Inter-Industry Trade. Although they are both similar in name they are different in meaning. Inter-industry refers to the trade of goods in different industries. Countries usually engage in inter—industry trade for competitive advantage, while intra-industry trade has been a key factor in the growth of trade between countries. “These trends have mostly been attributed to the fragmentation of production (outsourcing and offshoring) as a result of globalization and new technologies” (Handjiski et al, 2010). Although strange, intra-industry trading has proven to be beneficial to countries in several ways. Intra-Industry trading increases the variety of goods within the same industry, which benefits the consumer and businesses. Goods produced in the same industry can be highly differentiated and provide the opportunity for range within the market of the trading partners. Intra-Industry Trade also provides the opportunity for businesses to profit from economies of scale and competitive advantage when they produce specific types of products within a specific range. Lastly, while inter-industry trade can stimulate innovations within the industry in the case of short-term fluctuations in the economy, intra-industry trade the more same goods that can be produced the lower the unit costs, and the lower the price will be. On the basis of old trade theories, “intra-industry trade on a large scale, an undeniable fact of trade between modern industrial economies, is simply not a prediction of traditional trade theories” (Davis, 1995).

In trying to explain intra-industry trade using Heckscher-Ohlin Theorem it cannot fully explained. According to the theorem trade only occurs between industries, or inter-industry trade. Heckscher-Ohlin theorem suggests that the country that is capital abundant will specialize in production of capital intensive goods (cloth), which is imported by the foreign country. While the country is labor abundant specializes in the production of labor intensive goods (food) which is imported from the home economy. Heckscher-Ohlin Theorem does not account for economies of scale nor income distribution in intra-industry trade. More importantly the theorem only makes assumptions based on two countries with different import and exports that are highly specialized and abundant to produce. The countries work on comparative advantage rather competitive advantage. According to the theorem international trade will hurt other industries, while also benefiting some industries. According to the theorem international trade between the countries will total in price equalization even though the theorem itself is based on partial equilibrium. Heckscher-Ohlin Theorem emphasizes that, “economies export the services of their abundant factors and import the services of their scarce factors” (Ruffin, 1999). This statement from the theory contradicts the intra-industry trade on a fundamental level due to the lack of acknowledgement of other factors of international trade between countries.

In conclusion, Heckscher-Ohlin is an essential factor in the beginning of international trade theory that has branched out to other economic theories to explain trade domestically and internationally. The theorem explains the trade when, the country is abundant in capital will export the capital intensive good, and the country that is more labor abundant will export the labor intensive good. However the assumptions that the theorem makes is heavily criticized and is easily combatted when adding the dimension of intra-industry trade. The theorem doesn’t explain international trade between countries within the same industry but of different industries. The validity of the theorem doesn’t satisfy the notion of intra-industry trade because its assumptions does not account for economy specialization of the same product, although differentiate, within the same industry to be exported and imported.

References

Appleyard. Dennis, Field Jr., Alfred, Cobb, Steven. (2010). International Economics 7^th Edition. McGraw-Hill/Erwin.

Davis, Donald R. (1995). “Intra-Industry trade: A Heckscher-Ohlin-Ricardo Approach.” Journal of International Economics 39, pp. 201-226. http://www.columbia.edu/~drd28/Heckscher_OR.pdf

Handjiski, B, Lucas, R, Martin, P & Guerin, SS. (2010). “Enhancing Regional Trade Integration in Southeast Europe.” World Bank Publications

Jones, Palgrave. (n.d). “Heckscher-Ohlin Trade Theory.” Rochester University. pp. 1-15. http://www.econ.rochester.edu/people/jones/Palgrave_Jones_on_Heckscher_Ohlin.pdf

Jones, R.W. (1956). “Factor Proportions and the Heckscher-Ohlin Theorem.” The Review of Economic Studies. Vol. 24, No. 1, pp. 1-10. http://www.jstor.org/stable/2296232

Kemp, Murray. (2008). International Trade Theory: A Critical Review (Routledge Studies in International Business and the World Economy). Routledge Publishing.

Ruffin, RJ. (1999). “The Nature and Significance of Intra-industry Trade.” Federal Reserve Bank of Dallas. “Why Trade?”(2006). Nobelprize.org. Nobel Media. http://www.nobelprize.org/educational/economic-sciences/trade/ohlin.html