Heckscher-Ohlin Theory

 

Heckscher and Ohlin were two Swedish economists who built on the foundation provided by David Ricardo in his comparative advantage theory.  The Ricardian approach was based on differing labor productivity between countries, whereas the new approach was to be based on differing resource endowments between countries.  The new method gave a more theoretically complete explanation of the basis for international trade, and it provided some answers to questions not answered by Ricardo. 

 

The following discussion depends upon a basic understanding of the “production possibilities” topic.  If this topic from fundamental economics needs to be reviewed, it would be good to consult a basic text.  An appropriate web site could be looked at, as an alternative.  Here is one of the many sites listed by Google on the topic:  http://nova.umuc.edu/~black/ec2.html    

 

H-O postulates that countries are likely to have resource endowments that predispose them toward certain types of production for international trade.  Some countries are labor abundant and others are capital abundant.  Labor abundant countries will be good at making products which require a lot of labor.  Capital abundant countries will be good at making the things which require capital.

 

Starting from a situation where there is no international trade – called autarky -- and assuming two products and two countries, we can see how trade will evolve naturally.  The first country (the US?) is a capital abundant country and would naturally be good at auto production.  The other country (Mexico?) is labor abundant and would be good at making clothing.  More to the point, America could offer autos at lower (relative) prices in international trade than could Mexico, and the reverse would be true for the clothing.

 

If we were to argue from the perspective of production possibilities curves. the US would have a curve that was skewed in the direction of autos (elongated along the autos axis) and Mexico’s would be skewed the other way.  The simple interpretation would be to say that the US would take advantage of its superior ability to produce auto and would make extra autos for sale in Mexico.  Mexico would, in turn, move out along its production possibilities curve in the clothing products directions and would provide these products to the US as well as itself.  In the end the US would be specializing in cars, and Mexico would be specializing in clothing.  A natural basis for trade has emerged.

 

Going a little further, the price relationships mentioned above can be elaborated upon.  The relative price relationships can effectively be understood by considering opportunity costs.  The US will tend to have a relatively low price for cars (relative to the price of clothing).  This means that the amount of clothes which would equal one car would be a little in the US.  And the labor abundant country (Mexico) will have a relatively low price for clothing.  There, the amount of clothes per one car would be a lot.  These relative price relationships would be revealed in the slopes of the production possibilities curves for the two countries.  With the cars on the vertical axis of a production possibilities graph, and agricultural products on the horizontal axis, the curve for the US would be steep, the curve for Mexico would be flatter.

 

Autarky should give way to trade, because people will recognize that cars shipped to Mexico will fetch a good price, while clothes from Mexico will get a good price in the US.  Entrepreneurs will seize the opportunity to make money.

 

As trade takes place the specialization in the direction of car making in the US will increase.  Similarly, the specialization of Mexico into clothing making will increase. The cost of car making in the US will be driven up and the price of cars will rise. This is a standard conclusion of the production possibilities model in economics.  The more of a thing a country tries to make the more costly it is likely to become, because less well suited resources will eventually have to be employed.   In Mexico, clothing prices rise as demand increases and more production leads to rising costs.  Eventually, a uniform world price exists for cars and also for clothing.  Each country realize its full extent of specialization in "their" product at this point

 

So, we will move up and to the left on our production possibilities curve, and, formally speaking, the “law of increasing opportunity cost” indicates the cost of auto production will increase.  Since, in competitive conditions, price equals marginal cost, and marginal cost is increasing, the price of autos in the US will rise, and at the same time the price of autos will be falling in Mexico as lower cost American autos compete with the domestic production..

 

The opposite applies to agricultural goods.  The cost of producing each unit of ag. output goes up in Mexico as output expands.  Mexico is moving down and to the right on its production possibilities curve.   The price of agricultural goods in Mexico rises and it falls in the US.

 

The “law of one price” will hold.  That is, eventually the price of the two goods will equalize, because opporunities for gain will exist up until that point.  Of course, this conclusion of price equalization is understood to be “after factoring in the exchange rate” The essence is that profit incentives will lead to trade flows which will equalize prices.

 

When the dust settles, the US will be producing more cars than ever, and will be exporting some to Mexico, and at the same time importing agricultural goods.  Mexico will produce more ag goods than before, and will export some to the US, and will import cars from the US.  In the process of these changes, both countries will enjoy consumption possibilities combinations which are outside of their production possibilities curves -- they will achieve higher standards of living than under autarky. 

 

These predictions are generally reasonable.  Many commonly accepted economic principles are incorporated, the countries specialize, although not totally (incidentally, this is a problem for the Ricardo approach), a single price for each product exists.  On the other hand we might object to the fact that economies of scale may be ignored, and there are some assumptions which are not entirely realistic.  In any case this is a much admired piece of economic theory, and it is certainly “elegant”, and an impressive exercise in logic.

 

Let’s go further.

 

Enter Leontief -- a Harvard/NYU economist who is at thiss point very elderly or maybe deceased.  Leontief invented input-output analysis, a new branch of economics, which became important during and after WWII.  This technique involves studying and describing the relationship between inputs and outputs in the economy.  The end result is a table which shows the interrelationship between the different sectors of the economy.  For example one row of the table will show how the output of the steel industry is employed as inputs in the car industry, the railroad  industry, the refrigerator industry, the building construction industry, etc  The column for the steel industry will show what inputs go into the production of steel (like a recipe).  For example, so much energy is needed, iron ore is needed, transportation services to get the ore to the steel mills, etc.  All of these entries will be dollar amounts. 

 

This method of analysis is useful in sales forecasting and for other purposes.  It is said that early applications of the method led to efficient bombing target selection during WWII.  It is said that using this method it was determined that ball bearing plants made ideal targets since it was learned that (not surprisingly) these were essential inputs into the making of all kinds of war-time products. 

 

Anyway, Leontief realized that his tables were seemingly tailor made for studying HO theory.  The extent of labor intensity or capital intensity in the production of any many product could be learned by studying the tables.  He then reviewed the trade statistics to see what we were exporting and importing.  He reasoned that we would be found to be importing labor intensive goods and exporting capital intensive goods -- as HO suggests.  He found the opposite, that our imports tend to be capital intensive and our exports are labor intensive.

 

This surprise, called the Leontief Paradox has been an enduring puzzle in economics.  Does it mean that H-O is mistaken, or is there some other explanation?

 

Here are some thoughts which have been advanced to resolve the paradox.

1) The influence of labor organizations causes tariffs to be passed which distort trade--unions protect jobs, so labor intensive products are kept out by means of tariffs.

2) Our imports are coincidentally capital intensive: one major area of imports is ores and other natural resources.  These happen to be capital intensive production areas, but we should regard them as natural resource intensive products.  Thus the breakdown between capital and labor in the H-O theory is too narrow.

3) H-O assumes common tastes among the two countries.  This assumption is not valid, some argue. Speaking of tastes, maybe trade patterns can be explained more on the demand side of things than the production side. If we assert that trading partners get together on the basis of consumer tastes and preferences, we can understand the fact that we export cars to Europe at the same time they export cars to us (not what H-O would suggest).  Advanced countries with “rich” consumers will make natural trading partners.  Example: German coffee makers are a little different than ours, and our consumers like the “variety” they represent to us.

 

This brings us to modern theories of trade, of which, Vernon’s International Product Cycle Theory is a prime example.  We will pick this up in another commentary.