Factor Proportions Theory of International Trade

Almost after a century and a quarter of the classical version of the theory of international trade, two Swedish economists, Eli Heckscher and Bertil Ohlin, propounded a theory that is known as the factor endowment theory or the factor proportions theory. In fact, it was Eli Heckscher (1919) who mooted the notion of a country’s comparative advantage (disadvantage) based on relative abundance (scarcity) of factors of production. Later on, his student, Bertil Ohlin (1933) developed this notion of relative factor abundance into a theory of the pattern of international trade.

Factor Proportions theory of international trade  explains that in a two-country, two-factor, and two-commodity framework different countries are endowed with varying proportions of different factors of production. Some countries have large populations and large labour resources. Thus, a country with a large labour force will be able to produce the goods at a lower cost using a labour intensive mode of production. Similarly, countries with a large supply of capital will specialize in goods that involve a capital intensive mode of production. The former will export its labour intensive goods to the latter and import capital intensive goods from the latter. After the trade, both the countries will have two types of goods at the least cost (Ohlin, 1933).

All this means that the theory holds good if a capital abundant country has a distinct preference for the labour intensive goods and a labour abundant country has a distinct preference for capital intensive goods. If it not so, the theory may not hold good. Again, the theory does not hold good if the labour abundant economy is technologically advanced in capital intensive goods or if the capital abundant economy is technologically advanced in the production of labour intensive goods.

Samuelson (1948, 1949) introduced refinements to factor proportions theory by considering the effect of trade upon national welfare and the prices of the factors of production. He stated that the effect of the free trade among nations would be to increase the overall welfare by equating not only the prices of goods exchanged but also the prices of factors of production involved in the production of those goods in different countries. For example, the price of capital in the capital abundant economy of the USA will be much lower than that in case of the labour surplus economy of India. But after trade is established between the two countries, more capital intensive commodities will be produced in the USA. As a result, the price of capital will increase in the USA and the existing differential in this respect between the two countries will be lower. Similarly, more labour intensive commodities will be produced in India. Wage level will increase in India, with the result that the wage differential between level will increase in India, with the result that the wage differential between the two countries will be narrower.

Leontief (1954) put this theory to empirical testing and found in case of US trade during 1950s the country was exporting less capital intensive goods even when it had an abundance of capital compared to labour. Had the factor proportions theory been true, the USA would have exported more capital intensive goods. This is really a paradox, generally known as the Leontief Paradox. However, Leontief himself re-examined this issue and found that the paradox disappeared if the natural resource industries were excluded. Moreover, he found that the USA exported more labour intensive goods because the productivity of labour in this country was higher than in many labour abundant countries. According to him, even in case of labour abundant economics different countries differ in the sense that some countries posses a large skilled labour pool, whereas in other countries the labour resource may be largely unskilled. A country with a large skilled labour force will be to manufacture the same labour intensive product in a more capital intensive fashion and will be able to export that product to labour abundant countries where skilled labour is not employed in the manufacture of the same product. Thus, it is not only that factor endowments are not homogeneous; they differ along parameters other than that of relative abundance. Leontief’s later views find support in a couple of studies. The studies of Hufbauer (1966) and Gruber, Mehta, and Vernon (1967) reveal that improved technology was involved in the US export of labour intensive goods that characterized US exports as technology intensive rather than labour intensive.

Soon after Leontief’s study Tatemoto and Ichimura (1959) found that in the case of US-Japan trade, Japan exported labour intensive goods to the USA and imported capital intensive goods from the latter. Similarly, Bharadwaj (1962) found that in case of Indo-US trade, India mainly imported capital intensive goods from the USA and exported labour intensive goods to the latter in 1951. These two empirical tests support the Heckscher-Ohlin theory of international trade.