What is the Heckscher Ohlin Model?
The Heckscher-Ohlin model also known as The H-O model or 2X2X2 model is a theory in international trade that suggests that nations export those goods which are in abundance and which they can produce efficiently. This was developed by a Swedish economist Eli Heckscher and his student Bertil Ohlin and hence the name. Later, economist Paul Samuelson contributed a few additions and hence this model is referred to as a Heckscher-Ohlin-Samuelson model by a few.
Countries export products that they are abundant of or products for which they have the material/labor in abundance and such countries have a competitive advantage for such goods including land, labor, and capital and this is the basis for this model. Not just abundance, the cost of production or procurement has to be cheaper in such countries.
Why is it Called 2X2X2 Model?
The reason is simple, – there are two countries. Two countries engage in trading of two goods. There are two homogeneous production factors required for the same.
Assumptions of the Heckscher Ohlin Model
- There are two countries in the picture. This is used to make the model plainer and simpler.
- There are two factors – capital and labor. There is a constraint in factors i.e., the factors are limited to the funding (endowment) of the country.
- Countries have similar production technology. Countries will share the same technologies. Though it is not realistic, this assumption is taken so that it eliminates the trade differences because of technological differences.
- Prices are the same everywhere.
- The tastes in the two countries are identical. Similar to technology, this is assumed to eliminate the difference in tastes.
- The two countries have different relative factor endowments namely capital, land and labor. Based on the relative factor endowments, countries are classified as capital abundant, labor abundant or land abundant.
- Factor Intensities may vary. Similar to above, based on relative factor intensities, goods are classified as capital intensive, labor-intensive or land-intensive.
- Perfect CompetitionPerfect CompetitionPerfect competition is a market in which there are a large number of buyers and sellers, all of whom initiate the buying and selling mechanism. Furthermore, no restrictions apply in such markets, and there is no direct competition. It is assumed that all of the sellers sell identical or homogenous products.read more.
- Firms in the market get to choose the output level at which price equals marginal costs.
- In response to profit, there is free entry and free exit of firms in the market.
- Necessary information is available and is perfect.
- There are no transport costs and no hindrances in trade.
- There are no trade restrictions between the two countries.
Intuitions of Heckscher Ohlin Model
There is a large relative supply of a factor, say capital. This results in a low relative price of capital in the country. This, in turn, results in cheaper capital intensiveCapital IntensiveCapital intensive refers to those industries or companies that require significant upfront capital investments in machinery, plant & equipment to produce goods or services in high volumes and maintain higher levels of profit margins and return on investments. Examples include oil & gas, automobiles, real estate, metals & mining.read more goods in the country. And hence, the country would have a competitive advantage for that country which opens up the possibility of mutually beneficial trade.
Components of the Heckscher Ohlin Model
The four major components of the theory are as follows:
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For eg:
Source: Heckscher Ohlin Model (wallstreetmojo.com)
- Factor Price Equalization Theorem – The most fragile of all, The FPE states that the prices of factors of production will be equalized among countries because of international tradeInternational TradeThe trading or exchange of products and/or services across international borders is referred to as international trade. It frequently includes other risk factors such as exchange rate, government policies, economy, laws of the other nation, judicial system, and financial markets that impact trade between the two.read more.
- Stolper-Samuelson Theorem – The Stolper-Samuelson theorem (SST) proposed that, in any particular country, an increase in the relative prices of the labor-intensive goodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company's net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company's net identifiable assets from the total purchase price.read more make labor better off and capital worse-off and the converse also applies.
- Rybczynski Theorem – This Theorem depicts how changes in funding affect the output of the goods when there is full employment.
At constant prices, an increase in endowment of one factor will lead to an expansion in the output of the sector that uses that factor and will lead to a complete decline in output of the other good. - Heckscher-Ohlin Trade Theorem – This is a critical theorem of this model which boils down to this statement “a country having capital in abundance will produce goods that are capital intensive and a country having abundant labor will produce labor-intensive goods.
How is the Heckscher Ohlin Model Superior to Classical Theory?
- It is a better explanation of the world economy after the second world war.
- The traditional Ricardian theory overlooked the demand factors and completely focused on the supply factors. The H-O model is relatively better and takes into account both supply and demand.
- The Classical theory ignored capital and assumed labor as the only factor of production.
- The classical theory hence accredits any difference in costs to the differences in labor.
- The H-O model is hence more specific and realistic when compared to the classical theory.
- This model also brings about integration between trade theories and value theories.
Real-Life Example and Study
Saudi Arabia holds around 18% of the world’s petroleum reserves and ranks as the largest exporter of petroleum and second-largest producer. Petroleum in Saudi is not only available in plenty but also closer to the earth’s surface. Hence, it is cheaper and profitable to extract petroleum in Saudi Arabia than from many other places. This can be taken as an example of the H-O model.
Criticism
- Poor prediction and performance.
- The unfair assumption that all labor is employed. This model assumes that all labor in the country is employed thus ignoring the concept of unemployment.
- The unrealistic assumption that identical production exits. This model assumes that nations have the same technology being used for production undermining the effects and ignoring the technological gaps.
- Logical Flaws – Capital is assumed as being homogeneous and transferrable between countries.
To sum up, this model postulates that countries export what they can produce abundantly or what they already in abundance of (reserves) and a country will have a comparative advantageComparative AdvantageIn order to determine comparative advantage, the opportunity cost of each item from each country needs to be calculated. Then, on a comparative table, these costs are plotted to get the comparative advantage.read more in the good that uses its relatively abundant factor intensively. Though this model has been proven to be better than the traditional model, this model adopts assumptions that can hardly be expected to be fulfilled.
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