Heckscher Ohlin Model

In a globalized world, traces of other countries can be found in every commodity. Pick up your
phone, look where it is made, your mug, or maybe your snowboard. Can you imagine the
journey of a mug from a factory in another country to your desk? Even some commodities
contain parts from completely different countries. For example, probably the zipper of your
hoodie is made in one country, and the fabric of it is produced in another country. But how do
countries decide what should they produce? Heckscher-Ohlin's Model stresses this question
while depending on the classical economy. If you want to learn more about one of the most
fundamental models in international trade, keep reading!

Heckscher Ohlin Model of International Trade

Heckscher-Ohlin's model tries to explain the advantages of free trade with regard to some
fundamental assumptions. The model was developed by Eli Heckscher and Bertil Ohlin at the
Stockholm School of Economics in 1933. It takes the basic assumptions of David Ricardo’s
comparative advantages theory and expands it on a more theoretical plane.

In our world, every country has a different production strategy. This production strategy
generally depends on the country’s economic abundance of a specific material or production
inputs. Heckscher-Ohlin's model promotes an international trade structure that depends on this
relative abundance and comparative advantages.

According to the model, countries should trade with respect to the factor that they are
abundant to optimize their benefits. For example, if a country’s relative labor endowment is
rich, that country should export goods that require more labor to a country where labor
endowment is low.

Example:
We can give China an example of a country with a high labor endowment. China is the World’s
most populated country. Therefore, the supply of labor is high compared to other countries.
Since labor is a commodity, it is reasonable to assume that the law of demand and supply is
applicable to explain the fluctuations in price. Due to the high supply of labor, the wage rates
are low compared to the other countries with the same level of development. Indeed due to
this low wage rate, China produces more labor-intensive products such as shoes and clothes.
More than half of the world’s shoes are produced within the country’s factories.

Heckscher-Ohlin's model sets the scene where there exist two factors, two commodities, and
two goods. This is why it is also known as the “2X2X2” model. Like every other economic model,
Heckscher-Ohlin's model depends on some fundamental assumptions. Before explaining the
model, it is reasonable to elaborate on these assumptions.
Heckscher Ohlin Model Assumptions

The Heckscher-Ohlin model's assumptions state that there exist two countries, C 1 and C2. These
countries have the same technological structure and the same taste in consumption. We are
assuming such a structure to simplify things in the model. This removes the possibility of trade
with regard to technological differences and guarantees the consumption of goods without any
cultural differences.

Similar to the assumptions that we made for the two countries, we make assumptions for the
factors too. In the Heckscher-Ohlin model, we assume that traded goods can be produced with
regard to two different factors. Our first factor is capital, K, and our second factor is labor, L.

Moreover, we assume the existence of two goods with different compositions of factors. Our
first good, steel, requires more capital to produce when we compare it to cloth, which requires
more labor to produce.

Now let us assume that one country, C1 (America), has a capital endowment and the other
country, C2 (Britain), has a labor endowment. We can illustrate their endowments with the
following notation.

Kc1/Lc1 > Kc2/Lc2

In addition to this structure, Heckscher-Ohlin's model assumes a perfectly competitive market

where factors between countries are immobile. This indicates that one country’s workers can
not migrate to the other country. Similarly, one country’s companies can’t relocate their assets
to the other country.

Finally, factors are fully mobile within countries. This means that without any costs, the country
can alter its production structure and change it to different combinations of factors.

General assumptions:
 There are only two countries (C1 (America) & C2 (Britain))
 There are only two factors of production (labor and capital)
 Only two commodities are produced (steel and cloth)

To wrap it up, we can list the particular assumptions as follows:

 Both of these countries share the same technological structure and the same taste in consumption.
 No transportation cost and no trade barrier
 Perfect competition in both commodity and labor markets
 The production function is homogenous to degree one or constant return to scale
 The same commodities in two countries have the same intensities
 Factors of production are immobile between countries and mobile within countries
 Technology is the same in both countries
 No factor intensity reversal
Heckscher Ohlin Model Graph

Heckscher-Ohlin's model is easy to demonstrate with a graph. Let us assume that there exist
two countries, America (C1) and Britain (C2). C1 is capital endowed. Similarly, let’s assume that
there exist two goods, steel and cloth. Steel is a capital-intensive good and cloth is a labor-
intensive good. If there are two factors of production, labor, and capital, then we can say that
C1 will produce steel relatively cheaper than C2 since it is capital endowed. We can illustrate
their production possibilities frontier as follows.

Graph-1: PPF of two countries

In Figure 1, we can see how the two countries’ production possibilities frontier differs. Since C 1
is capital endowed, the production possibilities frontier of C1 is skewed towards the capital-
intensive good, steel. Similarly, C2 is labor endowed, and its production possibilities frontier is
skewed towards cloth since cloth is a labor-intensive commodity. Before trade, America
produces and consumes at R and Britain at R*.
But what will happen after the trade?

With many production techniques, the analysis remains essentially the same. The only
significant difference is that the production-possibilities frontiers of the two countries become
smoothly continuous (without kinks), as shown in Figure-2, country-C1's production-possibilities
frontier JH is skewed along the horizontal axis: and country-C2's frontier J*H* is skewed along
the vertical axis.

Graph-2: After trade scenario of two countries

Before trade. Country-C1 produces and consumes at R, where the nation's production-
possibilities frontier is tangent to social indifference curve 1. Country-C2's autarkic equilibrium
occurs at R*. (For convenience, we continue to assume that, in autarky, both countries attain
the same social indifference curve. This assumption can be dropped without serious
consequences.) In country-C1, the relative price of commodity-A is given by the slope of social
indifference curve-1 at R: and in country-C2, by the slope at R*. As before, commodity-
A (the capital- intensive commodity) is cheaper in country-C1 (the capital-abundant country),
because social indifference curve-1 is flatter at R than at R*.

With free trade, the relative price of steel rises in C1 and falls in C2 until it becomes the same in
both countries. The equilibrium terms of trade are given by the common slope of (parallel) lines
CQ and Q*C*, which connect the countries' production points (Q and Q*) to their consumption
points (C and C*) and form trade triangles CQV and Q*C*V*. C1 exports VQ (or V*C*) of
commodity-A in exchange for VC (or V*Q*) of country-C2’s cloth. Again capital-abundant C1
exports capital-intensive commodity- steel, and labor-abundant C2 exports labor- intensive
commodity- cloth. The proof of the Heckscher-Ohlin theorem is complete.

Heckscher Ohlin Model vs Comparative Advantage

Heckscher-Ohlin's model contains many similarities with David Ricardo’s comparative

advantage theory. On the other hand, they have fundamental differences too.

First of all, we should keep in mind that Ricardo’s comparative advantage model just takes one
factor of production, labor, as an argument. On the other hand, Heckscher-Ohlin's model
includes capital as a factor of production in the equation. Ricardo’s comparative advantage
theory assumes that the productivity of labor is different across countries. On the contrary, the
Heckscher-Ohlin model assumes the same level of technology, therefore, the same level of
productivity.

Secondly, Ricardo’s comparative advantage theory sets the scene in the short run. Due to the
fact that, in the long run, the productivity of the factors can change. Albeit the comparative
advantage theory, Heckscher-Ohlin's model discusses the mechanics of trade in the long run.
Therefore, the productivity related to technology is the same between the two countries.

Finally, in Ricardo’s perspective, the reason for the trade is the difference between the rates of
productivity across the two countries. In Heckscher-Ohlin's model, the reason for the trade
arises due to the different endowments of the two countries.

Criticism of Heckscher Ohlin Model

The criticism of the Heckscher-Ohlin model generally arises due to its assumptions. While going
over these criticisms, we should keep in mind that the theory was a big step in economics
literature since it offered a complete framework compared to the previous theories.

As a beginning, we can say that the theory is based upon just two goods and the trade arises
due to different endowment amounts between countries and different factor rates among
goods. Although simplifications are a necessary part of a model, these types of
oversimplifications may cause us to fail to understand the underlying mechanisms of trade.
Furthermore, the quantity of a factor is not the only source of production. The quality of a
factor is also vital for production.

Following this, we can state another problem; the absence of costs of trade. In the real world,
this is rather a challenging problem since costs may vary drastically with regard to
transportation and many other factors. These varying costs may cause different relative prices,
and the trade can be illogical due to increased transportation costs.

In addition to that, we can also point out the assumption of factor immobility between
countries. This is rather unrealistic since migrations happen between countries. Due to wage
rates, people migrate to different countries to work. This cannot be covered with the Hecksher-
Ohlin model. This also becomes an oversimplification of a more complex system. Finally, the
model overlooks the rate of technology. There are countries that depend on these
technological differences during international trade. Due to this assumption, the model
becomes more unrealistic and may veil our understanding of reality. Not just the technological
differences, but the model also doesn’t include the rate of technological change in the long run.

Heckscher-Ohlin Model - Key Takeaways

 Heckscher-Ohlin's model is a fundamental theory in international trade that states that
countries will produce and trade with regard to their endowments of factors.
 Heckscher-Ohlin's model assumes two countries where these countries trade two goods
that are made by different combinations of two factors.
 Heckscher-Ohlin's model is similar to the comparative advantages theory. Nonetheless, it
also differs from many perspectives, such as an additional factor of production, setting a
scene in the long run instead of the short run, and not including productivity differences

Difference between the Specific factor model and the Heckscher-Ohlin model

The main difference between the specific factor model and the Heckscher-Ohlin model is the
immobile factors in the short run within a country. The specific factor model can be seen as an
extension of the Heckscher-Ohlin model, where instead of fully mobile factors in the short run,
the specific factor model assumes immobile factors in the short run. Therefore, the trade may
be harmful even with regard to factors of production.
Leontief Paradox
In the early 1950s, Russian-born American economist Wassily W. Leontief studied the US
economy closely and noted that the United States was abundant in capital and, therefore,
should export more capital-intensive goods. However, his research using actual data showed
the opposite: the United States was importing more capital-intensive goods. According to the
factor proportions theory, the United States should have been importing labor-intensive goods,
but instead, it was actually exporting them. His analysis became known as the Leontief Paradox
because it was the reverse of what was expected by the factor proportions theory. In
subsequent years, economists have noted historically at that point in time, labor in the United
States was both available in steady supply and more productive than in many other countries;
hence it made sense to export labor-intensive goods. Over the decades, many economists have
used theories and data to explain and minimize the impact of the paradox. However, what
remains clear is that international trade is complex and is impacted by numerous and often-
changing factors. Trade cannot be explained neatly by one single theory, and more importantly,
our understanding of international trade theories continues to evolve.
 Rybczynski Theorem (1955)
Statement: An increase in a factor endowment will increase the output of the industry using
it intensively, and decrease the output of the other industry.

Suppose that I yard of cloth requires 4 units of labor plus 1 unit of capital and I ton of steel
requires 2 units of labor and 3 units of capital, as summarized in Table-1. Thus cloth is labor
intensive relative to steel because 4+1 >2+3. Assume further that the economy is endowed with
900 units of labor and 600 units of capital. Given these labor and capital requirements as well
as the sup plies of labor and capital, we can derive the economy's production-possibilities
frontier, as shown in Figure-1.

Table-1: Factor endowments

Inputs per unit of output

Labor Capital
Cloth 4 1
Steel 2 3

If the economy had an unlimited supply of capital, it would be able to produce along labor
constraint JG, which is similar to a Ricardian production possibilities frontier. Thus, employing
all its labor (900L) in the production of cloth, it would produce 225 yards (that is, 900÷4).
Employing all its labor in the production of steel, it could produce 450 tons (that is, 900÷2). By
allocating some labor to cloth and some to steel, it would produce output combinations lying
on JG.

If the economy had an unlimited supply of labor, it would be able to pro- duce along capital
constraint MH, which is similar to the labor constraint except that the roles of labor and capital
are reversed. For instance, by using all its capital (600K) to make steel, the economy could
produce 200 tons; by using all its capital to make cloth, it could produce 600 yards; and by
dividing its capital between steel and cloth, it could produce output combinations lying on MH.

When the supplies of labor and capital are limited, then both constraints be- come binding and
the production-possibilities frontier coincides with the heavy kinked line JEH. The economy
cannot produce beyond JE because of a shortage of labor, and it cannot produce beyond EH
because of a shortage of capital. But along JE some capital remains idle (and the return to
capital necessarily drops to zero). Along EH some workers remain unemployed (and the wage
rate drops to zero). The only point at which both factors are fully employed (with positive
rewards) is the intersection, E. of the two constraints.
Figure-1: Derivation of the PPF

In Figure-1, the capital constraint is steeper than the labor constraint. This is no accident.
Rather, it is a reflection of the fact that steel (the commodity measured horizontally) is capital
intensive relative to cloth. To understand why this is so, assume that the economy is currently
at full-employment point E, and let the economy increase the output of steel by moving to a
point such as V. Capital will remain fully employed (because V lies on the capital constraint), but
some workers will become unemployed (because V lies inside the labor constraint). The
increase in steel has absorbed all the capital, but not all the workers, released by the decrease
in cloth production. This means that steel uses more capital per worker than cloth: that is, steel
is capital intensive relative to cloth.

We are now ready to illustrate the Rybczynski theorem. In the figure-2, start at point E, at
which both factors are fully employed. Suppose that labor grows from 900L to 1,200L. How do
the full employment outputs of cloth and steel change? The answer is simple. The labor
constraint shifts outward in a parallel fashion from JG to J'G', and the production-possibilities
frontier becomes J'E'H. The full-employment point moves from E to E'. The output of cloth (the
labor-intensive commodity) rises from 150 to 240 yards, while the output of steel (the capital-
intensive commodity) falls from 150 to 120 tons. Thus the prediction of the Rybczynski theorem
is borne out.
Figure-2: Rybczynski theorem

Note that as labor grows, the output of the labor-intensive commodity must expand to absorb
the extra supply of labor. Because labor must be combined with capital and the supply of
capital remains fixed by assumption, the output of the capital-intensive commodity must
decrease absolutely in order to release the necessary amount of capital.
Stolper-Samuelson Theorem
Statement: An increase in the relative price of a good will increase the real return to the
factor used intensively in that good and reduce the real return to the other factor.

Consider the figure, which presents the production-possibilities frontier of a "small" open
economy, in America. Under free-trade conditions, America produces at Q and exports steel in
exchange for cloth. (To keep the diagram simple America's trade triangle is not shown.) To
protect its import-competing industry (cloth), America imposes a tariff on imports of cloth,
which raises the domestic relative price of cloth or lowers the relative price of steel. The first
impact of the change in relative prices is reflected in the profitability of the two industries. The
producers of cloth will enjoy positive profits, but the producers of steel will sustain losses. In
turn, the profits will induce the producers of cloth to expand their output, and the losses will
force the steel producers to curtail theirs. Suppose that America eventually moves from Q to Q'.

Even a small movement along the production-possibilities frontier implies total reorganization
of the structure of production. Not only do resources shift from one industry to the other, but
also the optimal methods of production, the optimal factor proportions (capital-labor ratios),
and the marginal productivity of both factors in both industries- and thus the internal
distribution of income-all change with the tariff. The essence of this complex reorganization we
captured by the Stolper-Samuelson theorem.