Name: NGENE Tobechukwu Anthony

ID Number: 20230288
Department: Economics (200L)

International Economics and Trade Policy Midterm Paper

Paper’s Contents:
● A review of the Heckscher-Ohlin Theory in the context of international
theory
● A comparison between the Heckscher-Ohlin Theory and the Theory of
Comparative Advantage
● The Firm Based Trade Theory
● The Product Life Cycle
The Heckscher-Ohlin (Factor Proportions) Theory
The factor proportions model was originally developed by two Swedish
economists, Eli Heckscher and his student Bertil Ohlin, in the 1920s. Many
elaborations of the model were provided by Paul Samuelson after the 1930s, and
thus sometimes the model is referred to as the Heckscher-Ohlin-Samuelson
(HOS) model. In the 1950s and 1960s, some noteworthy extensions to the model
were made by Jaroslav Vanek, and so occasionally the model is called the
Heckscher-Ohlin-Vanek model. Here we will simply call all versions of the model
either the Heckscher-Ohlin (H-O) model, or simply the more generic “factor
proportions model.”
The Heckscher-Ohlin Theory is a foundational concept in the international
economics context.The H-O Theory is an expansion of the Ricardian Model
largely by introducing a second factor of production (Labour). In its two-by-two-
by-two variant, meaning two goods, two factors, and two countries, it represents
one of the simplest general equilibrium models that allows for interactions across
factor markets, goods markets, and national markets simultaneously. It attempts
to explain the dynamics of trade amongst nations based on the relative
availability of factors of production(land, labour). The Heckscher-Ohlin theory
states that export goods that require intensive use of the factors of production
they have an abundance of. This implies that a country endowed with the supply
of labour will export labour-intensive goods and a country with an abundance of
capital will export capital intensive goods. Here’s a more practical example:

Country A has a lot of fertile land, so it has abundant agricultural resources like
soil and sunshine.
Country B, on the other hand, has a well-educated and skilled workforce, so it
has an abundance of labour.
According to the Heckscher-Ohlin theory, Country A is likely to specialise in
producing agricultural products because it has lots of land, and it can produce
these goods more efficiently.
Meanwhile, Country B might produce things that require skilled labour, like
technology or machinery.
As a result, Country A will export agricultural products to Country B, and Country
B will export technology or machinery to Country A. This trade benefits both
countries because they can get the goods they don't have in abundance, rather
than by trying to produce everything themselves.
The Heckscher-Ohlin theory is a useful tool for understanding global trade in the
21st century. The theory provides a framework for analysing the factors that
influence trade patterns and the potential benefits of trade.

Assumptions of the Heckscher-Ohlin Model

● 2X2X2 Framework: There are two countries, two goods, and two factors of
production (labour and capital).
● Factor Mobility within Countries: Two factors of production, Labour and
Capital, can move freely between the countries.
● Factor Immobility across countries: Labour and capital cannot move
between countries.
● Identical Technology: The technologies used to produce the two goods are
identical across the countries.
● Endowments: The only difference between countries assumed in the
model is a difference in endowments of capital and labour.
● Factor Constraints: The total amount of labour and capital used in
production is limited to the endowment of the country.
● Constant Returns to Scale: Doubling inputs results in a double of outputs.
● Perfect Competition: Markets for goods and factors are perfectly
competitive, with no monopolies or oligopolies.
● No Transportation Costs or Trade Barriers: Goods can move freely
between countries without tariffs, quotas, or logistical costs.
● Homogeneous Preference: Consumer tastes are the same across
countries, and preferences for computers and shoes do not vary with a
country’s level of income.
These assumptions are very important to the validity of the H-O theorem. If
the factor intensity of production changes, the theorem cannot be
considered valid, as a good may be both labour-intensive and capital-
intensive at different factor price ratios. In that case, the basic premise of
the theorem breaks down.

Real World Applications of the Heckscher-Ohlin Model

The H-O Model provides a powerful insight to understanding real-world trade
sequences and patterns. It is particularly useful in explaining why certain
countries tend to export and import certain goods based on the factors they are
endowed with.
● Labour Intensive Goods:
Countries with abundant, low-cost labour specialise in and export labour-
intensive goods like textiles and garments. For instance, Bangladesh’s ready-
made garment (RMG) sector accounts for over 80 percent of its export earnings,
using its low wage labour force to maximum advantage.
● Capital Intensive Goods:
More developed countries specialise in high value, capital-intensive goods such
as cars, machinery, advanced electronic products etc. Germany is a global
leading exporter of automobiles, producing luxury cars like BMW, Mercedes
Benz that rely on high capital investment.

Criticisms and Extensions of The Heckscher-Ohlin Theory

Real World Limitations:
● Technological Differences: Countries often have different levels of
technology, which in fact does influence trade patterns.
● A common criticism is the assumption of perfect competition, which
may not hold in real world markets.
● Non-Homogeneous Preferences: Consumer tastes vary widely across
countries, affecting trade patterns.
● Trade Barriers and Transport Costs: Tariffs, quotas, and logistical
constraints disrupt the smooth functioning of trade predicted by the model.
● Dynamic Factors: Economic growth, resource depletion, and
advancements in production methods can alter a country's factor
endowments over time.

The Leontief Paradox

 The Leontief Paradox is a term used when referring to the first empirical
test of the H-O Theory, conducted in 1953 by Wassily Leontief. Leontief's
discovery challenged the Heckscher–Ohlin model of international trade, which
predicts that countries will export goods that use the factors of production in
which they are most abundant.The Leontief Paradox is a theory that stipulates
that a country’s exports do not necessarily reflect the factor that is most abundant
in that country. This theory stemmed from Leontif’s paradoxical discovery that the
United States, the most capital-intensive country by all criteria, in fact exported
mostly labour-intensive commodities and imported capital-intensive commodities.

The Leontief Paradox goes to expose the flaws and the failure of the H-O
model to take into account factors such as human capital, natural resources and
consumption patterns. This paradox spurred debate and further research, leading
to refinements of the theory.

Heckscher-Ohlin Theory and the Theory of Comparative Advantage

Comparative Advantage Theory
In the context of international trade, a country has comparative advantage
at producing a good if it can produce it at a lower cost than any other country.
This theory is foundational in international economics and it explains why
countries benefit from specialising in the production of goods and services in
which they have a relative advantage.
When David Ricardo first illustrated the importance of comparative
advantage in the early 1800s, he solved a problem that had eluded even Adam
Smith Comparative advantage explains why a country might produce and export
something its citizens don’t seem very skilled at producing when compared
directly to the citizens of another country! (For example, in the past few years
India has become a major supplier of phone-answering services for the American
market, even though their English-language skills are not up-to-par.) The
explanation of the apparent paradox is that the citizens of the importing country
must be even better at producing something else, making it worth it for them to
pay to have work done by the exporting country. Amazingly, the citizens of each
country are better off specialising in producing only the goods at which they have
a comparative advantage, even if one country has an absolute advantage at
producing each item.
Key Concepts of Comparative Advantage:
 1) Absolute Advantage: Comparative advantage refers to the ability to
produce goods and services at a lower opportunity cost, not necessarily at
a greater volume or quality. Absolute advantage, on the other hand, is
when a country can produce more of a good or service in greater volume
and with fewer resources than any other country. Absolute advantage
refers to the superior production capabilities of an entity, while comparative
advantage is based on the analysis of opportunity cost.
Illustration of Absolute Advantage:
Suppose there are two countries, Country A and Country B, and two goods,
Wheat and Cloth:

● In one hour, Country A can produce:

4 units of Wheat or 2 units of Cloth.

● In one hour, Country B can produce

2 units of Wheat or 2 units of Cloth.

Here:

● Country A has an absolute advantage in Wheat production.

● Neither country has an absolute advantage in Cloth (both produce 2 units).

Opportunity Costs:

● For Country A:

1 unit of Cloth = 2 units of Wheat.

1 unit of Wheat = 0.5 units of Cloth.

● For Country B:

1 unit of Cloth = 1 unit of Wheat.

1 unit of Wheat = 1 unit of Cloth.

Since Country A has a lower opportunity cost for producing Wheat, it should
specialise in Wheat. Country B, with its lower opportunity cost for Cloth, should
specialise in Cloth. This means Country A has comparative advantage in
production of Wheat and Country B has comparative advantage in the production
of Cloth.

2) Specialisation: Ricardo argued that countries should specialise in

producing goods where they have a comparative advantage and trade for
goods where other countries have a comparative advantage. This allows
all trading partners to benefit through increased overall production and
consumption.
3) Opportunity Cost: This term is central in the discussion of comparative
advantage. It measures the trade-off of producing one good over another.
Even if one country is less efficient in producing all goods (lower absolute
productivity), it can still benefit from trade by focusing on goods with the
lowest relative production cost.

The Heckscher-Ohlin Theory and the theory of Comparative Advantage

are two foundational concepts in International Economics and are closely
associated, although they differ in purpose, functionality and focus.

Here is a comprehensive comparison between the two concepts:

Concept

● Comparative Advantage Theory: Explains trade based on differences in

opportunity costs and relative productivity between countries.
● Heckscher-Ohlin Theory: Explains trade based on differences in factor
endowments (e.g., labour, capital, land).

Focus

● Comparative Advantage Theory: Countries should specialise in goods

where they have a lower opportunity cost.
● Heckscher-Ohlin Theory: Countries specialise in producing and exporting
goods that use their abundant production factors intensively.

Key Driver of Trade

● Comparative Advantage Theory: Differences in technology and

productivity.
 ● Heckscher-Ohlin Theory: Differences in resource availability (factor
abundance).

Mechanism

● Comparative Advantage Theory: A country exports goods in which it has a

comparative advantage (lower opportunity cost) and imports goods in
which it has a comparative disadvantage.
● Heckscher-Ohlin Theory: A country exports goods that intensively use its
abundant factors (e.g., labour-abundant countries export labour-intensive
goods) and imports goods that use its scarce factors.

By and large, the comparative advantage theory explains trade based on relative
productivity differences while the H-O model explains trade on the basis of factor
endowment differences. Regardless, the two concepts are imperative to
economists for offering insights into why certain goods are produced and traded
by specific countries.

The Firm-Based (Modern)Trade theory

International trade theories are simply different theories to explain

international trade. Trade is the concept of exchanging goods and services
between two people or entities. International trade is then the concept of this
exchange between people or entities in two different countries.

In contrast to classical, country-based trade theories, the category of

modern, firm-based theories emerged after World War II and was developed in
large part by business school professors, not economists.The firm-based theory
is a modern approach to international trade that emphasises the roles of
individual firms (especially in the context of multinational corporations), rather
than countries, as key players in explaining trade patterns. This theory has
emerged as an extension of classical and neoclassical trade theories, such as
comparative advantage and the Heckscher-Ohlin model, which focus on country-
level factors like resource endowments and productivity differences. Unlike the
country-based theories, the firm-based theory incorporates other product and
service factors, including brand and customer loyalty, technology, and quality,
into the understanding of trade flows.

The firm-based theory emerged as a result of the growth of the

multinational companies. The country-based theories failed to adequately
address either the expansion of the MNC’s or intra-industry trade. The country-
based theories couldn’t adequately address the expansion of either MNCs or
intra-industry trade, which refers to trade between two countries of goods
produced in the same industry. For example, Japan exports Toyota vehicles to
Germany and imports Mercedes-Benz automobiles from Germany.

The Product Life Cycle

The product-life cycle emerged in the 1960s through the work of Harvard
Business School professor, Raymond Vernon. The product life cycle in the
context of international trade explains how a product evolves through different
stages of production and how it affects trade patterns and occurrences. The
theory, originating in the field of marketing, stated that a product life cycle has
four distinct stages:

New Product:

● Characteristics:
○ A new product is developed and introduced in the domestic market
of an innovating country (usually a developed nation).
○ Production is concentrated in the innovating country due to
advanced technology, skilled labour, and proximity to the initial
consumer base.
● Trade Implications:
○ Exports of the product begin to nearby or advanced countries where
there is demand.
○ Limited international competition as the product is novel.

Growth:

● Characteristics:
○ Demand increases domestically and internationally.
○ The innovating country continues to dominate production, but foreign
firms may start imitating the product.
● Trade Implications:
○ Export volumes grow significantly.
○ The product may begin to be produced in other advanced countries
to meet increasing demand.

Maturity:

● Characteristics:
○ The product becomes standardised, and production processes
become routine.
 ○ Market demand stabilises in developed countries and expands in
developing countries.
○ Price competition intensifies as multiple producers emerge globally.
● Trade Implications:
○ Production shifts to developing countries where labour and
manufacturing costs are lower.
○ The innovating country may start importing the product it initially
exported.

Decline:

● Characteristics:
○ The product faces saturation in global markets and may be replaced
by newer innovations.
○ Sales decline as demand shifts or the product becomes obsolete.
● Trade Implications:
○ Production may fully migrate to low-cost developing countries.
○ The innovating country focuses on newer, high-value products rather
than maintaining declining ones.

Conclusion

This paper explores key theories of international trade—Heckscher-Ohlin Model,

Comparative Advantage, Firm-Based Trade Theory, and the Product Life Cycle—
emphasising their interconnected roles in explaining trade dynamics. The
Comparative Advantage principle highlights that nations trade goods they produce
relatively efficiently, while the Heckscher-Ohlin Model refines this by linking
production specialisation to countries’ resource endowments (labour, capital, land).
Firm-Based Trade Theory shifts focus from countries to firms, explaining how firm-
specific advantages like innovation, branding, and economies of scale drive trade.
The Product Life Cycle Theory integrates these

perspectives, demonstrating how comparative advantage evolves over time, with

innovations originating in developed countries, production shifting to lower-cost
regions, and firms leveraging global networks. Together, these theories provide a
cohesive framework for understanding trade flows, from resource allocation to firm
strategies and market dynamics.

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