36095794 factor endowment theory

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FACTOR ENDOWMENT THEORY

The factor endowment theory was developed by Swedish economist Eli Heckscher

and his student Bertil Ohlin. This theory consists of two important theorems, namely,

the Heckscher-Ohlin theorem and the factor price euilisation theorem. The

Heckscher-Ohlin theorem e!amines the reasons for comparative cost differences in

production and states that a country has comparative advanta"e in the production of

that commodity which uses more intensively the country#s more abundant factor. The

factor price euali$ation theorem e!amines the effect or international trade on factor

prices and states that free international trade euali$es factor prices between countries,

relatively and absolutely, and thus serves as a substitute for international factor

mobility.

Heckscher-Ohlin Theorem

Heckscher and Ohlin have e!plained the basis of international trade in terms of factor

endowments. The classical theory demonstrated that the basis of international trade

was comparative cost difference. However it made little attempt to e!plain the causes

of such comparative cost difference attempts to e!plain why comparative cost

differences e!ist internationally. They attribute international differences in

comparative costs to%

&. 'ifferent prevailin" endowments of the factors of production, and

(. The fact that production of various commodities reuires that the factors of

production be used with different de"rees of intensity.

)n short, it is the difference in factor intensities in the production functions of "ood

alon" with actual differences in relative factor endowments of the countries whiche!plains international differences is comparative cost of production.

)n the Heckcher-Ohlin model, factors of production are re"arded as scarce or

abundant in relative terms and not in absolute terms. That is one factor is re"arded as

scare or abundant in relation to the uantum of other factors. Hence, it is uite

possible that even if a country has more capital, in absolute terms, than other

countries, it could be poor in capital. * country can be re"arded as richly endowed

with capital only if the ratio of capital to other factors is hi"her when compared to

other countries.



+i )n ountry *%

Supply of labour (/ units

Supply of capital (0 units

apital-labour ratio 0.1

+ii )n country B%

Supply of labour &( units

Supply of capital &/ units

apital-labour ratio &.(/

)n the above e!ample, even thou"h ountry * has more capital in absolute terms,

ountry B is more richly endowed with capital because the ratio of capital to labour

in ountry * +0.1 is less than in ountry B +&.(/.

*ssumptions

a. Both product and factor markets in both countries are characteri$ed by perfect

competition.

b. 2actors of production are perfectly mobile within each country but immobile

between countries.

c. 2actors of production are of identical uality in both countries.

d. 2actor supplies in each country are fi!ed.

e. 2actors of production are fully employed in both the countries.

f. 2actor endowments of one country vary from that of the other.

". There is free trade between the countries, i.e., there are no artificial barriers to

trade.

h. )nternational trade is costless, i.e., there is no transport cost.

i. Techniues of producin" identical "oods are the same in both countries. 'ue

to this, the same input mi! will "ive the same uantity and uality of output in

the countries.

3. 2actor intensity varies between "oods. 2or instance, some "oods are capital

intensive +i.e., they reuire relatively more capital for their production and

some others are labour intensive +i.e., they reuire relatively more labour for

their production.

k. 4roduction is sub3ect to the law of constant returns, i.e., the input-output ratio

will remain constant irrespective of the scale of operation.



Factor Price Equalisation Theorem

The factor price euali$ation theorem states that free international trade euali$es

factor prices&/ between countries, relatively and absolutely, and this serves as a

substitute for international factor mobility.

The international trade increases the demand for abundant factors +leadin" to an

increase in their prices and decreases the demand for scarce factors +leadin" to a

fall in their prices because when nations trade, speciali$ation takes place on the

basis of factor endowments. *ccordin" to Ohlin, 5The effect of inter-re"ional

trade is to euali$e commodity prices. 2urthermore, there is also a tendency

towards euali$ation of the prices of factors of production.

The followin" fi"ure shows the production decisions based on factor endowment

by Heckscher-Ohlin theorem in different countries.

Merits o Heckscher-Ohlin Theor!" The Heckscher 6 Ohlin theory has certain

definite merits.

&. The Heckscher6Ohlin theory ri"htly points out that the immediate basis of

international trade is the difference in the final price of a commodity

between countries, althou"h the actual basis or ultimate cause of trade is

comparative cost difference in production. Thus, the Heckscher-Ohlin theory

provides a more comprehensive and satisfactory e!planation for the

e!istence of international trade.

(. *lthou"h the 7icardian theory points out that comparative cost difference is

the basis of international trade, it does not e!plain the reasons for the



e!istence of comparative cost differences between countries. The Heckcher-

Ohlin theory e!plains the reasons for the differences in the cost of

production in terms of differences in factor endowments. This is another

aspect that makes it superior to the 7icardian analysis.

8. The classical theory implicitly assumes that international trade will come to

an end if the labour cost of production of commodities become eual every

where, whereas the Heckscher-Ohlin become eual every where because of

the differences in the factor endowments.

9. :hile the classical theory is based on comparative differences in the labour

costs of production of commodities between countries, the Heckscher-ohlin

theory is more realistic as it considers the differences in the production

function 6 production cost and price.

Eects o #nternational Tra$e

The Heckscher-Ohlin theory indicates that international trade will ultimately have the

followin" results%

&. Eualisation of ommodity 4rices

(. Eualisation of 2actor 4rices

Em%irical o H-O Mo$el

Some notable attempts have been made to empirically test the validity of the

Heckscher-Ohlin ;odel. * brief account of some of them are "iven below%

&eontie Para$o'

The credit for makin" the first comprehensive and detailed verification of the

Heckscher-Ohlin theory "oes to :assily :. <eontief.

The =nited States of *merica was believed to be a country with abundant capital

endowment and scarce labour endowment. Then, if the factor proportions theory were

correct, the =S should have been e!portin" capital intensive commodities and

importin" labour intensive commodities. However, the result of <eontief#s test

disproved this hypothesis. This parado!ical result of test, that showed that the =nited

States was actually e!portin" labour intensive "oods and importin" capital intensive

"oods, came to be popularly known as the <eontief 4arado!.

36095794 factor endowment theory

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