Foreign Trade Dersi 3. Ünite Özet

Basis of the Factor Endowments and the Heckscher-Ohlin Theory

Classical Trade Theory which has been accepted as the primer of the international trade theory assumes that the country whose labor is more productive in producing the commodity that is subject to international trade has a comparative advantage in this commodity. Briefly, the basis of international trade solely depends on the differences of labor productivity. Theory of Absolute Advantage of Adam Smith and the Theory of Comparative Advantage of David Ricardo are based on the labor theory of value. Labor theory of value assumes that the price of a commodity is determined by the amount of labor going into the production of the commodity.

So as to understand the reasons for the development of the Heckscher-Ohlin Theory, it’d be adequate to explain the weaknesses of the Neo-Classical Trade Theory that prevailed before the Heckscher-Ohlin Theory. The NeoClassical Trade Theory postulates that as long as the relative commodity prices are different, there is always an incentive for beneficial trade. In other words, the differences in relative commodity prices induce international trade between countries.

Early international trade economists assumed that each trading country would have its own production conditions, its own climate, its own geography and these differences between countries would lead to the differences in productivity. However, the economists of the twentieth century have extended the scope of the differences in productivity. The first studies in this respect are the models of the two Swedish economists, namely Eli Heckscher and Bertil Ohlin.

In the international trade analysis, production possibilities frontier (PPF) represents the total supply of the trading country while total demand is exhibited by the indifference curve which represents the total demand of a country. PPF is the boundary between the combination of two commodities that can be produced and those that cannot. In order to explain the PPF, we assume two hypothetical commodities, namely corn and wheel at a time, and keep the quantities of the other commodities and services constant. The production possibilities frontier of corn and wheel of our hypothetical country, Sunland, gives the limits of the production of corn and wheel, given the total resources available to produce them (as it is shown on the 58. page of the book in Figure 3.1).

An indifference curve is a line that gives the combinations of commodities between which a consumer is indifferent. An indifference curve is a part of an indifference curves map which can be referred as preference map. The fundamentals of an individual’s indifference curve are analogous to a country’s indifference curve. Since we analyze the international trade between countries, we are going to use the community indifference curves (as it is shown on the 59. page of the book in Figure 3.2).

Marginal rate of substitution is an important determinant in preference analysis. The marginal rate of substitution (MRS) is the rate at which Sunland will give up wheel to get an additional unit of corn and at the same time remain indifferent. The magnitude of the slope of an indifference curve is referred as marginal rate of substitution (as it is shown on the 60. page of the book in Figure 3.3).

Simplifying Assumptions of the Factor Endowments and the Heckscher-Ohlin Theory

The Factor Endowments and the Heckscher- Ohlin Theory, or simply the Heckscher-Ohlin Theory, developed upon the weaknesses of the previous theories has some simplifying assumptions. Instead of examining them at the stage where the analysis stands, it’d be more effective to give them before starting to analyze the theory as a whole. The Heckscher-Ohlin Theory stands on twelve simplifying assumptions:

1. Two countries, two commodities and two factors of production.
2. One of the commodities is labor-intensive and the other one is capital-intensive in both countries.
3. One of the countries is labor-abundant and the other one is capital-abundant.
4. Technology is the same in both countries.
5. There is constant returns to scale in the production of both commodities.
6. There is incomplete specialization in the production in both countries.
7. Demand preferences are the same in both countries.
8. There is perfect competition in the commodities and the factor markets in both countries.
9. There is free movement of factors of production within each country but no free movement of factors of production between countries.
10. There is free trade between the trading countries.
11. There is full employment in all resources in both of the trading countries.
12. International trade between the trading countries is balanced.

Heckscher-Ohlin Theory

Heckscher-Ohlin Theory was developed so as to respond to two questions that had not been answered by the Classical Trade Theory: (1) What is the determinant of the comparative advantage of the countries? (2) How does international trade affect the earnings of the factors of production within the trading countries? The second question is directly related with the distribution of income effects of international trade.

Heckscher-Ohlin Theory states that comparative advantage of the trading countries are explained exclusively by differences in relative supply conditions. Essentially, the Theory accepts the trading countries’ factor endowments (resource endowments) as the main determinant of their comparative advantage. For example, according to the The Heckscher-Ohlin Theory, China exports textiles because it is heavily-endowed with labor that is the main factor of production in textile production. So as to conceive the postulations of the Heckscher-Ohlin Theory as a whole and adapt it to the real world, we use our hypothetical example of Sunland and Lakeland, producing corn and wheel. We take into account all the simplifying assumptions of the Heckscher-Ohlin Theory and do the general equilibrium analysis (as it is shown on the 66. page of the book in Figure 3.5).

Distribution of Income Effects of International Trade

International Factor Price Equalization Theorem

As international trade begins, the relative commodity prices start to change due to the basic supply and demand law. According to the Heckscher-Ohlin Theory, the convergence of the relative commodity prices continues until they become equal to each other. International Factor Price Equalization Theorem postulates that relative factor prices also converge and are equalized with international trade. International Factor Price Equalization Theorem is sometimes referred as Heckscher-Ohlin-Samuelson (H-OS) Theorem since Paul Samuelson improved the basic Heckscher-Ohlin Model by his assumptions on the relative factor prices.

Even though the implications of the Heckscher- Ohlin Theory on the international distribution of income sound logical, we don’t experience such a proper international factor price equalization in our real world. Due to some unrealistic assumptions of the Theory, international factor price equalization cannot be fully met within the world trade. Despite the free trade assumption of the Theory, countries mostly impose trade restrictions on their international trade. In spite of the assumption on the absence of transportation costs, there are transportation costs in the real world. Both the trade restrictions and the transportation costs affect the commodity prices and thus lead todifferences in commodity prices between trading countries. If commodity prices are not the same, then we cannot have an equalization on the factor prices. Although the factor prices are not equalized at the international level, they approximate to each other in the real world.

Stolper-Samuelson Theorem

Stolper-Samuelson Theorem depends on the International Factor Price Equalization Theorem. In spite of the similarities between them, Stolper Samuelson Theorem explains the distribution of income effects of international trade within a trading country while International Factor Price Equalization Theorem deals with the international distribution of income effects of international trade.

The Stolper-Samuelson analysis starts with the basic recognition that an income of an individual solely depends on the inputs he/she provides to the economy. Labor earns wages, owners of capital earn profits while owners of land earn rent. Simply, the demand for and the supply of the input of an individual determine his/her income. The demand for an input might be referred as derived demand because it is derived indirectly from the demand for the final output no matter it is a final commodity or a service. If the demand for the final output is high, the price of it will be high, as well. Thus, the inputs that are used in the production of this output will enjoy higher returns. In other words, the income of the inputs will be increased.

The final conclusion of the Stolper-Samuelson Theorem is that an increase in the price of a commodity raises the income earned by the factors of production that are widely used in its production. Since international trade increases the price of the exported commodity of a country, income earned by the factors of production that are intensively used within the exported commodity will be raised.

Although the assumptions of the Stolper- Samuelson Theorem seem logical, it constitutes the initial stage in explaining the distribution of income effects of international trade. The Theorem can be extended by taking into consideration the magnification effect. According to the magnification effect, an increase or a decrease in the price of a commodity has a greater effect in the same direction on the income of the factor used intensively in its production.

Validity of the Heckscher-Ohlin Theory as a Whole

We have analyzed the Heckscher- Ohlin Theory. However, we need to know the validity of the Theory as a whole. In this respect, we are going to examine the Specific Factors Model, the Factor Intensity Reversal, and the Leontief Paradox.

Specific Factors Model

The Specific Factors Model explains how international trade is realized under the short run factor immobility within the Heckscher-Ohlin Theory context. The Specific Factors Model should be concerned as an extension of the Heckscher- Ohlin Theory since it does not reject it. According to the Specific Factors Model, the factor mobility that is assumed by the Heckscher-Ohlin Theory can only be attained in the long run. Thus, the distribution of income effects that are explained by the StolperSamuelson Theorem are valid in the long run. Specific Factors Model postulates that some of the factors of production can be immobile or can only be used in the production of a commodity. In this case, this factor will be a specific factor for the production of this specified commodity.

Specific Factors Model postulates that, in the short run, there is labor mobility (free movement of labor) but capital immobility in the production of some commodities within a country. Certainly, such an immobility has different consequences on the distribution of income effects of international trade. In other words, the conclusions of the Stolper-Samuelson Theorem do not prevail as a whole, at least in the short run. However, it can be possible to move the immobile factor from the production of a commodity to the production of the other in the long run.

Factor-Intensity Reversal

Factor-Intensity Reversal explains the situation in which a commodity is the labor-intensive commodity in the laborabundant country and the capital-intensive commodity in the capitalabundant country. The Factor-Intensity Reversal rests on the elasticity of substitution of factors of production. The elasticity of substitution of factors of production determines the degree upto which one factor can be substituted for another in production as the relative price of the factor decreases.

When Factor Intensity Reversal exists, neither the Heckscher-Ohlin Theory nor the International Factor-Price Equalization Theorem and the Stolper- Samuelson Theorem hold. The reason of this null is that the comparative advantage of each trading country is no longer valid as it was. However, it should be kept in mind that the condition of the existence of the Factor Intensity Reversal is large elasticity of substitution of factors of production.

Leontief Paradox

The first empirical test on the validity of the HecskcherOhlin Theory was the study of Wassily Leontief. Leontief did this empirical study in 1951 using the US data of 1947. Depending on the Heckscher-Ohlin Theory, he aimed to examine the US international trade. Certainly, Leontief hoped to find that the US exported capitalintensive commodities and imported labor-intensive commodities because the US was deemed to be a capitalabundant country, exporting capitalintensive commodities and importing laborintensive commodities.

However, the results that Leontief found out were very surprising. According to the results of Leontief ’s study, the US exports labor-intensive commodities and imports capital-intensive commodities. Since the results contradict with the Hecskcher-Ohlin Theory, the study of Leontief is widely known as Leontief Paradox. After obtaining the contradicting results, Leontief had two alternatives to conclude; to reject the Hecskcher-Ohlin Theory or to find a way to rationalize his results. He chose the second alternative and explained his results without rejecting the Theory.

There is another explanation of the Leontief Paradox that is also unacceptable. This second explanation was based on the differences in tastes. According to the second explanation, US tastes were in favor of the capitalintensive commodities, and this preference was the main reason of the higher relative prices of the capital-intensive commodities.

Presumably, the most significant contribution of the Leontief Paradox on the validity of the Heckscher-Ohlin Theory was that it reminded the importance of human capital. Human capital is composed of education and training of the labor, which increases their productivity. Thus, not only the physical but also the human capital has to be a matter of fact within the factor endowments analysis. Since the US labor encompasses more human capital than those of other countries, the human capital that is added on the physical capital justifies the capitalabundance of the US. Following this assumption, the exports of the US have to be capital-intensive commodities compared to the import-substitutes.

In terms of the overall validity of the Heckscher-Ohlin Theory within the twenty first century, we reach to an important conclusion: The Hecskcher-Ohlin Theory is still an influential theory within the international trade theory. However, it is particularly successful and thus valid in explaining the international trade among the least developed and developed countries today since they meet the features of the laborabundant and capital-abundant countries. Nevertheless, it is weak in explaining the trade among the countries that have similar factor abundance. For example; we cannot analyze the trade between two capital-abundant countries by the Hecskcher-Ohlin Theory. We need to rely on new trade theories that improve the Hecskcher-Ohlin Theory.