Modern Theory of International Trade

Heckser-Ohlin Theory

1. MODERN THEORY OF INTERNATIONAL
TRADE (HECKSCHER-OHLIN THEORY)
Dr. LaxmiNarayan
Assistant Professor Economics
Govt. P.G. College, Mahendergarh
E-mail:[email protected]

2. STATEMENT
Examines the basis of comparative
advantage.
Difference in relative factor endowments
and factor price is main reason for
difference in comparative advantage.
A nation will export the commodity in the
production of which a relatively large
amount of its abundant and cheap
resource is used and vice-versa.

3. ASSUMPTIONS
2x2x2Model.
FactorMobility.
PrefectCompetition.
Identical Demand.
ProductionFunction.
-Identical;
-NoChange;
-LinearHomogenousofDegreeOne.
…..>>>>

4. Free Trade with no Restrictions.
Zero Transportation Costs.
No Factor Intensity Reversal.
Full Employment.
Quantitative Difference in Factors but
Qualitatively Homogenous.
Classification of Goods Based on Factor
Intensity.

5. EXPLANATION
Difference in relative commodity prices is the
immediate causeof international trade.
Difference in commodity prices is due to the
difference in the factor prices.
Difference in factor prices is due to the
difference in factor endowments.
Thus,goodwhichusesmoreofabundantfactor
willberelativelycheapasrelativefactorpriceof
abundantfactorwillberelativelylow.

6. CRITERION OF FACTOR ABUNDANCE
There are two criterion of classifying a country
as labour/capital abundant or labour/capital
scarce.
(i) Physical Criterion
(ii) Price Criterion

7. PHYSICAL CRITERION
Based on the physical quantity.
The country whose capital-labour ratio is
greater is called capital abundant.
Let us assume that Germany(G) and India(I)
are two countries, then, Germany is capital
abundant if:
Here, KGis quantity of capital in Germany
and KIin India; LGis quantity of labour in
Germany and LI in India.K
G K
I
L
G L
I

8. DIAGRAMATIC EXPLANATION
Shape:Skewed Toward Y Axis.
Germany:Capital-Abundant Nation;
Watches:Capital-Intensive;
India:
Labour-Abundant
Shirts:
Labour-Intensive
Shape:Skewed
Toward X-Axis.
…>>>>
GERMANY
Y
X
0 I
1
I
Y
X
0 I
1
I
INDIAWATCHES
SHIRTS

9. GERMANYGERMANY
Y
I
I
Y
X
O
INDIAINDIAWATCHE
S
SHIRTS
PIPI
PGPGG
R
B
A
G1
If both countries produce in same ratio
then Germany will produce at point ‘B’
and India at point ‘A’.
Ray ‘OR’ represents production of shirts
and watches in same proportion.
Slope of Germany
constraint line(P
G)
at point B is steeper
then India's P
I.

10. This shows that given factor endowments
Germany can produce comparatively
more watches and India more shirts.
Hence, India will export shirts and import
watches from Germany.
The analysis in terms of physical
quantity of factors of production consider
supply aspectonly.
…>>>>

11. It shows that capital-abundant country
Germanyhas a bias in favour of capital-
intensive commoditywatches and labour
abundant India in labour intensive shirts.
It does not show that the capital-abundant
countrywill export capital-intensive
commodity.It depends on the nature of
demand.
To understand this we have to consider price
criterion of factor abundance.

12. PRICE CRITERION
Based on the prices of factors of production.
The country where capital is relatively cheap
is called capital abundant even if quantity of
capital is relatively more.
Let us assume that Germany(G) and India(I)
are two countries, then, Germany is capital
abundant if:
PKis price of capital; PLis price of labour
GERMANY INDIA
PK PK
PL PL

13. SSand WWiso-productcurves
for both countries.
DIAGRAMMATIC EXPLANATION
AB and A
1B
1 are iso-cost line
for Germany.
PQ and P
1Q
1are iso-cost line
for Germany.
A
B
P
Q
P
1
Q
1
X
Y
O
LABOUR
LABOUR
CAPITAL
S100 Shirts
W25 Watches
S
W
E
25 Watches
100 Shirts
B
1
A1

14. Slope of iso-cost lines AB
and PQshows that capital
is relatively cheap in
Germany and labour is
relatively cheap in India.
The iso-product curves crosses only at point ‘E’
Indicating no factor intensity reversal.A
B
A
B
P
Q
P
Q
P
1
Q
1
P
1
Q
1
X
Y
O
LABOUR
LABOUR
CAPITAL
S100 Shirts
W25 Watches
S
W
E
25 Watches
100 Shirts
X
Y
O
LABOUR
LABOUR
CAPITAL
S100 Shirts
W25 Watches
S
W
E
25 Watches
100 Shirts
X
Y
O
LABOUR
LABOUR
CAPITAL CAPITAL
S100 Shirts
W25 Watches
S
W
E
25 Watches
100 Shirts
B
1
A1
B
1
A1

15. FOR GERMANY:
Production Cost of 25 Watches
= ‘GH’ Capital+ ‘FH’ Labour
Production Cost of 100 Shirts
= ‘GH’ Capital+ ‘FJ’ Labour
This shows that production
cost of 100 shirts is more than
25 watches by ‘JH’(FJ-JH)
amount of labour. ……(i)E
S100 Shirts
S100 Shirts
W25 Watches
W25 Watches
O
X
Y
LABOURLABOUR
CAPITAL
E
S100 Shirts
S100 Shirts
W25 Watches
W25 Watches
O
X
Y
LABOURLABOUR
CAPITAL
LABOURLABOUR
CAPITAL CAPITAL
A
1
B
1B
A
F
H
J
IG

16. P
QQ
1
P
1 E
S100 Shirts
S100 Shirts
W25 Watches
W25 Watches
O
X
Y
K
L
M
N
T
LABOURLABOUR

CAPITAL
FOR INDIA:
Production Cost of 25 Watches
= ‘TL’ Labour +‘KM’ Capital
Production Cost of 100 Shirts
= ‘TL’ LABOUR+ ‘LM’ Labour
This shows that production
cost of 100 shirts is less than
25 watches by ‘KL’(KM-LM)
amount of capital. ……(ii)

17. From (i) and (ii) we can conclude that as labour-
abundant Indiacan produce labour-intensive
shirtsat relatively lesser cost, it would
specialise in the production of shirts and should
export it.
Likewise, Germany should produce and export
watches.

18. FACTOR PRICE EUALITY
Whentwocountriesstarttrading,thenthe
factorpriceswillbeequalinthelong-run.
BecauseIndiawillproducemoreoflabour
intensiveshirts,hencedemandforlabour
andwageratewillriseinIndia.
AndasGermanyimportlabourintensive
goods,itsdemandforlabourandwage
ratewilldecline,tillwagerateinboth
countriesequalise.

19. COMPARISION BETWEEN
CLASSICAL & MODREN THEORY
Modern theory: 2x2x2 model.
H-O explains the Causes.
Based on money cost.
Classical theory give importance to labour
alone.
Considers inter-national trade as a special
case of inter-regional trade.
Classical ignored factor endowment.
…>>>>

20. Classical theory describes advantages of
trade whereas modern theory its basis.
Classical theory assumes different
production function whereas modern
theory assumes same production function.
Modern theory forecast factor price
equality.

21. CRITICISM
2x2x2 model
Leontief’s paradox.
Static theory.
No constant tastes.
Factors are not homogeneous.
Production techniques are not
homogeneous.
Wrong argument of goods prices.
Partial equilibrium analysis.

22. IMPORTANT QUESTIONS
1.Critically examine modern theory of international
trade.
2.Explain factor endowment. Give Ohlin arguments
about its importance in explaining international
trade.
3.Explain price criterion of factor abundance.
4.Write short notes on:
(I) Factor Price Equality;
(Ii) Leontief Paradox;
(Iii) Factor Intensity Reversal.

23. REFERENCES
M.L.Jhingan,“InternationalEconomics”Konark
Publication,NewDelhi.
T.R.Jain,O.P.Khanna&VirSen,“Development
andEnvironmentalEconomicsandInternational
Trade”V.K.Publications,NewDelhi.
B.O.Soderston“InternationalEconomics”
Macmillan,London.
StevenM.Suranovic,“InternationalTradeTheory
andPolicy”athttp://internationalecon.com/Trade/
Tch60/T60-0.php