FREE ESSAY ON INTERNATIONAL TRADE

INTERNATIONAL TRADE

INTERNATIONAL TRADE (EC549)
EDI HOUADRIA ESSAY #1
Subject #2: Does the Leontief paradox invalidate the Heckscher-Ohlin model of trade?
Why and how countries trade has always been a difficult and capital question for
economists. The Ricardian model explained trade patterns through differences in labour
productivity, however international trade can only partially be explained this way. It
has also been wildly believed that resource allocation also plays a vital role in how
nations trade, Heckscher-Ohlin (H-O), two Swedish economists, were the first to integrate
resource allocation in an economic model of trade now referred to as the Heckscher-Ohlin
model of trade. This theory was generally accepted when it was published. However
Leontief published empirical data about USAtrading (1953) that was largely inconsistent
with the H-O theory of trade. Since then data about what countries trade has been so
inconsistent and confusing that there is no real empirical data supporting the H-O model
of trade. Thus there are flaws in the original H-O theory; the questions now are : why
isn't there any empirical data, and under what conditions is it possible to make the
model consistent with reality?
The H-O theory is also called the factor proportion theory this is because it stresses
the importance of the allocation of different factors of production, and what proportion
they play in what countries trade. This model is capable of explaining the different
input combinations producers may face, which is the optimal one and thus the comparative
advantage the nation thus possesses.
The simplest way to explain this model is by explaining how it works in a two-factor
economy (two kind of industries with two kinds of inputs), and what happens when this
economy opens to trade with a twin nation.
Thus we have a nation who produces two goods i.e. cloth and food, and these goods
necessitate two factors of production i.e. land and labour, of course this is set under
the conditions of pure and perfect competition thus both factors are mobile. This model
explains how the variations of the price or quantity of one factor can have an influence
upon the other. For example if the quantity of land suddenly varies this will have little
effect upon cloth who is more labour intensive, on the other hand food who is more land
intensive will probably have an important price and wage variation ; therefor it is
possible to assume that there is an important correlation between the rent of land and
the wages of labour, and there is also correlation between the price of food and the
price cloth (as illustrated beneath). Depending on these ratios a country can determine
in what kind of sector it has a comparative advantage. This is due to the 
Input possibilities in food production
fact that changes in the different factors affect the different sectors in a
disproportionate manner advantaging one and disadvantaging the other.
If this nation comes to open to trade with another nation, this will lead to factor price
convergence, the workforce involved in the countries most abundant factor gain , whereas
on the other hand the owners of the countries most scarce resource will probably lose
from trade, there are though, important suppositions, both countries produce both goods,
technologies are the same, no barriers to trade. Thus trade equalises the relative price
of all factors, this is because trade is but a mask, for countries through food and cloth
are in fact trading factor endowments and labour.
The US which is the country in the world with the most capital per unit of labour, and
thus has a comparative advantage in capital intensive goods. Applying the H-O model to
the US should reveal that it exports capital intensive goods. However Leontief studied US
exports for the 25 years following World War2, and revealed that US imports were
consistently more capital intensive than it's exports which goes against all the
conclusions of the H-O model. The study also outlined the fact that US exports were more
skill intensive. This study shatters all the assumptions of the H-O theory because the US
is one of the most liberal nations, and one whose sheer economic size means that if it is
not possible to include it in the H-O theory, how much is the H-O really worth?
Since then many have addressed the issue but even there studies are confusing however
some seem to be pointing in the right direction. First of all it seems that economists
have wrongly been considering the nature of what can be considered as a factor in the H-O
model. The factors considered should be immobile in the sense that this combination of
factors (in those specific proportions and quantities), is unique to this particular
nation(i.e. natural resources and labour). However many economists have considered
capital as being one of those factor inputs. But capital nowadays is something that can
travel more freely than ever. This is largely due to the fact that many free trade areas
have been created (EU, NAFTA...), and the appearance of big trans-national companies that
can easily move large sums of capital to a subsidiary branch in another nation. Another
assumption that greatly hinders the H-O model of trade is the fact that it assumes that
technology is the same everywhere and even though machines can be bought it can be argued
that technology is relatively immobile, thus creating greater differences in the needs of
firms to operate with skill or unskilled labour.
Another problem is how the different sectors have evolved ; the primary sector depends
much more upon natural resource allocation than any other sector. Natural resources are
truly immobile and specific to a country thus the H-O model applies quite well to
patterns of trade applied to primary goods. On the other hand it is more complicated to
compare and set a pattern of inter-sector trade because of the difference between the
nature of primary agricultural goods (traded by the south) and industrial goods (traded
by the north). This is because agricultural goods prices have a tendency to fall or
increase relatively slowly compared to the price of industrial goods who increase
rapidly. Thus the benefits of trade implied in the H-O model can be greatly deformed or
void.
However it is important to point out that the evidence that arises from the Leontief
report against the H-O model must be taken into it's context, the US has a unique status,
in the fact that it is the technologically most advanced country in the world which maybe
implies that it specialises in exports of relatively new sophisticated products, which
are maybe to sophisticated to be produced by capital instead of skill. Thus explaining
why it imports more mature products from heavy manufactures that are more capital
intensive.
It is now clearer what are the weaknesses of the H-O theory, however it is possible to
make it perform relatively well under certain conditions. First of all it is necessary to
chose factors that are immobile the best examples of this is of course is the level of
skill amongst labour relative to their wages, and the natural resources of a country.
Secondly if capital should be included it should under the form of interest rates, a
country with a lower interest rate (compared to world average), thus has a comparative
advantage in capital endowments. However this can be generally omitted because interest
rates do not change much from a country to another. Finally H-O must be applied to
sectors where resource allocation is crucial because like North South trading or primary
products, otherwise similarities between nations can make endogenous factors come into
account like national preferences or protectionism (to a certain extent).
The H-O theory is a very complete instrument that can help if correctly used with the
right factors in the right sectors. However it is far from giving us a complete general
theory on how countries trade. The limitations thus imposed restrict it mainly to
north-south trading, it also helps put into perspective the true role of labour skill in
trade patterns as well as the role of technology. The H-O model is not the truth but
simply an instrument that can give us an idea what the big picture is.
Bibliography
Bibliography
-P.Krugman, "International Economics", International Edition.
-A.Wood, "Give Hecksher and Ohlin a Chance", SLC.
-W.Staiger "An evaluation of factor endowments and...",SLC