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 equilisation theorem. The
Heckscher-Ohlin theorem examines the reasons for comparative cost differences in
production and states that a country has comparative advantage in the production of
that commodity which uses more intensively the country’s more abundant factor. The
factor price equalization theorem examines the effect or international trade on factor
prices and states that free international trade equalizes factor prices between countries,
relatively and absolutely, and thus serves as a substitute for international factor
mobility.

Heckscher-Ohlin Theorem

Heckscher and Ohlin have explained 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 explain the causes
of such comparative cost difference attempts to explain why comparative cost
differences exist internationally. They attribute international differences in
comparative costs to:

1. Different prevailing endowments of the factors of production, and

2. The fact that production of various commodities requires that the factors of
production be used with different degrees of intensity.

In short, it is the difference in factor intensities in the production functions of good

along with actual differences in relative factor endowments of the countries which
explains international differences is comparative cost of production.

In the Heckcher-Ohlin model, factors of production are regarded as scarce or

abundant in relative terms and not in absolute terms. That is one factor is regarded as
scare or abundant in relation to the quantum of other factors. Hence, it is quite
possible that even if a country has more capital, in absolute terms, than other
countries, it could be poor in capital. A country can be regarded as richly endowed
with capital only if the ratio of capital to other factors is higher when compared to
other countries.
 (i) In Country A:
Supply of labour = 25 units
Supply of capital = 20 units
Capital-labour ratio = 0.8

(ii) In country B:
Supply of labour = 12 units
Supply of capital = 15 units
Capital-labour ratio = 1.25

In the above example, even though Country A has more capital in absolute terms,
Country B is more richly endowed with capital because the ratio of capital to labour
in Country A (0.8) is less than in Country B (1.25).
Assumptions

a. Both product and factor markets in both countries are characterized by perfect
competition.
b. Factors of production are perfectly mobile within each country but immobile
between countries.
c. Factors of production are of identical quality in both countries.
d. Factor supplies in each country are fixed.
e. Factors of production are fully employed in both the countries.
f. Factor endowments of one country vary from that of the other.
g. There is free trade between the countries, i.e., there are no artificial barriers to
trade.
h. International trade is costless, i.e., there is no transport cost.
i. Techniques of producing identical goods are the same in both countries. Due
to this, the same input mix will give the same quantity and quality of output in
the countries.
j. Factor intensity varies between goods. For instance, some goods are capital
intensive (i.e., they require relatively more capital for their production) and
some others are labour intensive (i.e., they require relatively more labour for
their production).
k. Production is subject 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 equalization theorem states that free international trade equalizes
factor prices15 between countries, relatively and absolutely, and this serves as a
substitute for international factor mobility.

The international trade increases the demand for abundant factors (leading to an
increase in their prices) and decreases the demand for scarce factors (leading to a
fall in their prices) because when nations trade, specialization takes place on the
basis of factor endowments. According to Ohlin, “The effect of inter-regional
trade is to equalize commodity prices. Furthermore, there is also a tendency
towards equalization of the prices of factors of production.

The following figure shows the production decisions based on factor endowment
by Heckscher-Ohlin theorem in different countries.

Merits of Heckscher-Ohlin Theory: The Heckscher – Ohlin theory has certain

definite merits.

1. The Heckscher–Ohlin theory rightly points out that the immediate basis of
international trade is the difference in the final price of a commodity
between countries, although 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 explanation for the
existence of international trade.
2. Although the Ricardian theory points out that comparative cost difference is
the basis of international trade, it does not explain the reasons for the
 existence of comparative cost differences between countries. The Heckcher-
Ohlin theory explains 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 Ricardian analysis.
3. The classical theory implicitly assumes that international trade will come to
an end if the labour cost of production of commodities become equal every
where, whereas the Heckscher-Ohlin become equal every where because of
the differences in the factor endowments.
4. While 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 – production cost and price.

Effects of International Trade

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

1. Equalisation of Commodity Prices

2. Equalisation of Factor Prices

Empirical of H-O Model

Some notable attempts have been made to empirically test the validity of the
Heckscher-Ohlin Model. A brief account of some of them are given below:

Leontief Paradox

The credit for making the first comprehensive and detailed verification of the
Heckscher-Ohlin theory goes to Wassily W. Leontief.

The United States of America was believed to be a country with abundant capital
endowment and scarce labour endowment. Then, if the factor proportions theory were
correct, the US should have been exporting capital intensive commodities and
importing labour intensive commodities. However, the result of Leontief’s test
disproved this hypothesis. This paradoxical result of test, that showed that the United
States was actually exporting labour intensive goods and importing capital intensive
goods, came to be popularly known as the Leontief Paradox.