INTERNATIONAL TRADE

Dr. Nahla Azzam

Lecturer of economics
Faculty of Economic Studies
and Political Science (ESPS)
Alexandria University

Email:
[email protected]
Lecture (7)
12/11/2023
2023/2024
Part 1: International Trade Theory

Chapter (5)

Factor Endowments and the

Heckscher-Olin Theory
Main points:

1. Introduction.
2. Assumptions of the Theory.
3. Factor Intensity, Factor Abundance, and the Shape of the
Production Frontier.
4. Factor Endowments and the Heckscher-Olin Theory.
5. Factor-Price Equalization.
6. Factor intensity reversal.
 1. Introduction:
• In previous chapters, the theory of comparative advantage advocated that
differences in relative commodity prices between nations, are the basis for
mutually beneficial trade.

• Classical economists (Smith, Ricardo, and Mill) claimed that differences in

relative commodity prices- hence in comparative advantage- between nations
was due to differences in labor productivity between countries, however, they
didn’t provide any explanation for such differences between nations.
Therefore, they left two main questions unanswered, that is:
➢ Why relative commodity prices or productivity differs from one nation to
another ?
➢ What is the effect of international trade on the earnings of labor as well as on
international differences in earnings?
• Heckscher followed by his student Olin extended the standard trade model
to examine the basis for comparative advantage and the effect that trade has
on factor earnings in the two nations.
• Therefore, the H-O theory is considered a complementary rather than a
substitute for the comparative advantage theory, where it agrees with its
main hypothesis that specialization based on differences in comparative
advantage realizes the highest possible gains from trade, hence it is a strong
basis for trade. However, it goes beyond that by trying to explain differences
in comparative advantage between nations.
• Heckscher focused on explaining the reasons for differences in relative costs
based on differences in relative prices of FOP due to differences in relative
endowments of these FOP i.e., he focused on the supply side only.
• Ohlin rephrased Heckscher theory by adding some necessary conditions
(assumptions) that considered both the demand side as well as on the
supply side, for the acceptance and validity of Heckscher theory.
 2. Assumptions of the theory
➢ The H-O theory is based on the following assumptions:
1. There are two nations (N1 & N2), two goods (X & Y), two factors of production (K
& L).
2. Both nations use the same technology in production.
3. Commodity X is labor intensive and commodity Y is capital intensive in both nations
4. Both commodities are produced under Constant returns to scale in both nations.
5. There is incomplete specialization in production in both nations.
6. Tastes are equal in both nations.
7. Both commodities and factors are traded in perfectly competitive markets.
8. Perfect factor mobility within each nation, but not between nations.
9. No transportation costs, tariffs or other barriers to free trade.
10. All resources are fully employed in both nations.
11. International trade between the two nations is balanced.
 3. Factor Intensity, Factor Abundance, and the shape of
the Production Frontier
3.1 Factor Intensity:
In a two-commodity, two factor world:

• Commodity Y is capital intensive if the capital labor ratio (K/L) used in the
production of Y is greater than (K/L) used in the production of X.

• Example:
if the production of Y requires 2K & 2L, while X requires 1K & 4L, then:
𝑲 𝟐 𝑲 𝟏
(𝒀) = = 1 ,and 𝑿 =
𝑳 𝟐 𝑳 𝟒

That is, (Y) is K intensive and (X) is L intensive

Note that:
• It is not the absolute amount of capital and labor used in production of X
and Y, but the amount of capital per unit of labor (K/L) that determines
capital intensity.

• Example:
➢ If X requires 3K & 12L & Y requires 2K & 2L.
➢ Even though to produce 1X it requires 3K and to produce 1Y it requires 2K,
Y is still the capital-intensive commodity because K/L is higher for Y than it is
for X, where:
𝑲 𝟐 𝑲 𝟑 𝟏
(𝒀) = = 1 ,and 𝑿 = =
𝑳 𝟐 𝑳 𝟏𝟐 𝟒
 Factor Intensities for X and Y in N1 and N2 is graphically illustrated as
follows:

• The lines shown above reflects the production of each commodity in each
nation.
• The slope of each line measure the K/L ratio in the production of the
commodity.
• K/L is higher (slope of the line is steeper) for Y than for X, then commodity
Y is K-intensive, while commodity X is L-intensive.
 o Notice that:
• Even though Y is K-intensive relative to X in both nations, N2 uses higher
K/L in producing both Y & X compared to N1,where:

𝑲 𝑲 𝟏
In N1 (𝒀) = 1 ,and 𝑿 =
𝑳 𝑳 𝟒

𝑲 𝑲
In N2 (𝒀) = 4 ,and 𝑿 =𝟏
𝑳 𝑳

• Why does N2 use more K-intensive production techniques in both

commodities than N1?
➢ That is because capital must be relatively cheaper in N2 than in N1, therefore
producers in N2 use relatively more capital in the production of both
commodities to minimize their cost of production.
3.2 Factor Abundance:
There are two ways to define factor abundance:
I. In terms of physical units (supply side only):
• In terms of the overall amount of K & L available in each nation.
• A nation is said to be K-abundant if the ratio of the total amount of K to the total
amount of L available in such nation is greater than that available in the other nation.
Such that if:
(TK/TL) in N2 > (TK/TL) in N1
⸫N2 is K-abundant & N1 is L- abundant
✓ N.B. It is not the absolute amount of K & L in each nation that is important, but the
ratio of total amount of K to total amount of L.
• Thus, N2 can have less K than N1 and still be capital abundant if the previous
condition prevails.
• e.g., if TL= 600, TK = 1200 in China, while TL = 300, TK= 900 in India
⸫ TK/TL(China) = 1200/600 = 2 , while TK/TL (India) = 900/300 = 3
⸫ India is the K-abundant nation, though TK in China is greater than TK in India.
II. In terms of relative factor prices (supply and demand sides):
• In terms of the rental price of K & L in each nation.
• A nation is said to be K-abundant if the ratio of the rental price of K (interest
rate r) to the price of L time (wage rate w) in such nation is lower than that in
the other nation. Such that if:
(r/w) in N2 < (r/w) in N1
⸫N2 is K-abundant & N1 is L- abundant
• Similarly, It is not the absolute level of r & w in each nation that is important,
but the ratio (r/w).
• Thus, r may be higher in N2 than in N1, but it is still considered a K-abundant
nation if the previous condition prevails.
• e.g., if r = 12, w = 4 in N1, while r = 16, w = 8 in N2
⸫ r/w (N1) = 12/4 = 3 , while r/w (N2) =16/8 = 2
⸫ N2 is still the K-abundant though r in N1 is lower than r in N2.
3.3 Factor abundance and the shape of the Production Frontier:
• Since N2 is the K-abundant nation,
and Y is the K-intensive
commodity, then N2 can produce
relatively more Y than N1, and
hence its PPF is skewed towards
the vertical axis which measures Y.

• Similarly, since N1 is the L-

abundant nation and X is the L-
intensive commodity, then N1 can
produce relatively more X than
N2, and hence its PPF is skewed
towards the horizontal axis which
measures X.
 4. Factor Endowments and the Heckscher-Olin Theory:
4.1 The H-O theorem states that:
“A nation will export the commodity whose production requires the
intensive use of the nation’s relatively abundant and cheap factor and
import the commodity whose production requires the intensive use of the
nation’s relatively scarce and expensive factor”.
• Or in other words, the relatively labor-rich nation exports the relatively labor-
intensive commodity and imports the relatively capital- intensive commodity.
Example:
• N1 exports X, because X is the L-intensive commodity and L is the relatively
abundant and cheaper factor in N1.
• N2 exports Y, because Y is the K-intensive commodity and K is the
relatively abundant and cheaper factor in N2.
• Thus, the H-O theory explains the comparative advantage rather than
assumes it.
 4.2 The general equilibrium framework of H-O theory:

• The H-O theorem isolates the difference in relative factor abundance, or factor
endowments among nations as the basic cause or determinant of comparative
advantage and international trade i.e. (in case of equal tastes and technology)
• It postulates that differences in relative factor abundance and prices is the
cause of pretrade differences in relative commodity prices between nations.
4.3 Illustration of the H-O theory: