Theories of World Economy

Agenda

• The Heckscher–Ohlin theory• Leontief’s paradox• Theorem Ribchinsky

1. The Heckscher–Ohlin theory

• The Heckscher–Ohlin model (H–O model) is a general equilibrium mathematical model of international trade, developed by Eli Heckscher and Bertil Ohlin at the Stockholm School of Economics.

• It states that a country will export goods that use its abundant factors intensively, and import goods that use its scarce factors intensively.

• In the two-factor case, it states: "A capital-abundant country will export the capital-intensive good, while the labor-abundant country will export the labor-intensive good."

Assumptions of Heckscher-Ohlin's (H-O) Theory

• There are two countries involved.• Each country has two factors (labour and

capital).• Each country produce two commodities or

goods (labour intensive and capital intensive).• There is perfect competition in both commodity

and factor markets.• Factors are freely mobile within a country but

immobile between countries.

Assumptions of Heckscher-Ohlin's (H-O) Theory

• Two countries differ in factor supply.• Each commodity differs in factor intensity.• The production function remains the same in different

countries for the same commodity. For e.g. If commodity A requires more capital in one country then same is the case in other country.

• There is full employment of resources in both countries and demand are identical in both countries.

• Trade is free i.e. there are no trade restrictions in the form of tariffs or non-tariff barriers.

• There are no transportation costs.

Understanding The Concept of Factor Abundance

• In the two countries, two commodities & two factor model, implies that the capital rich country will export capital intensive commodity and the labour rich country will export labour intensive commodity.

Initially, when the countries are not trading:

• the price of capital-intensive good in capital-abundant country will be bid down relative to the price of the good in the other country,

• the price of labor-intensive good in labor-abundant country will be bid down relative to the price of the good in the other country.

Once trade is allowed, profit-seeking firms will move their products to the markets that have

(temporary) higher price. As a result:• the capital-abundant country will export the

capital-intensive good,• the labor-abundant country will export the

labor-intensive good.

Heckscher Ohlin's Theory has been criticised on basis of following grounds:

• Unrealistic Assumptions : Besides the usual assumptions of two countries, two commodities, no transport cost, etc. Ohlin's theory also assumes no qualitative difference in factors of production, identical production function, etc. All these assumptions makes the theory unrealistic one.

• Restrictive : Ohlin's theory is not free from constrains. His theory includes only two commodities, two countries and two factors. Thus it is a restrictive one.

• One-Sided Theory: According to Ohlin's theory, supply plays a significant role than demand in determining factor prices. But if demand forces are more significant, a capital abundant country will export labour intensive good as the price of capital will be high due to high demand for capital.

• Static in Nature: Like Ricardian Theory the H-O Model is also static in nature. The theory is based on a given state of economy and with a given production function and does not accept any change.

• Consumers' Demand ignored: Ohlin forgot an important fact that commodity prices are also influenced by the consumers' demand.

• Other Factors Neglected: Factor endowment is not the sole factor influencing commodity price and international trade. The H-O Theory neglects other factors like technology, technique of production, natural factors, different qualities of labour, etc., which can also influence the international trade.

2. Leontief's paradox

• Leontief's paradox in economics is that the country with the world's highest capital-per worker has a lower capital/labor ratio in exports than in imports.

• This econometric find was the result of Professor Wassily W. Leontief's attempt to test the Heckscher-Ohlin theory empirically. In 1954, Leontief found that the U.S. (the most capital-abundant country in the world) exported labor-intensive commodities and imported capital-intensive commodities, in contradiction with Heckscher-Ohlin theory ("H-O theory").

Reasons of Leontief’s paradox• The availability of natural resources was

ignored• Usually governments use trade barriers • The differences of consumer preferences • U.S. has an advantage in highly skilled labor

3. Theorem Ribchinsky

• The theorem is the assertion that, if the value of one of the two factors of production increases, then to maintain the constancy of prices of goods and factors necessary to increase the production of the product, which is intensively used, this factor is increased, and reduce the production of the rest of the production, intensively using a fixed factor.

• To the prices of goods remained constant, the same should be the price of factors of production. Prices of factors of production can remain constant only in the case when the ratio of the factors used in the two sectors remains constant.

• If growth is one factor can only take place with increasing production in the industry, which relies heavily on this factor, and reducing production in other industries, leading to the release of a fixed factor, which will be available for use together with a growing factor in the growing industry.