modern theory of international trade

MODERN THEORY OF INTERNATIONAL MODERN THEORY OF INTERNATIONAL TRADE TRADE (HECKSCHER-OHLIN THEORY)(HECKSCHER-OHLIN THEORY)

Dr. Laxmi Narayan Assistant Professor Economics

Govt. P.G. College, MahendergarhE-mail: laxmi_narayan70@yahoo.com

STATEMENTSTATEMENT

Examines the basis of comparative advantage.

Difference in relative factor endowments and factor price is main reason for difference in comparative advantage.

A nation will export the commodity in the production of which a relatively large amount of its abundant and cheap resource is used and vice-versa.

ASSUMPTIONSASSUMPTIONS

2x2x2 Model.

Factor Mobility.

Prefect Competition.

Identical Demand.

Production Function.- Identical;- No Change;- Linear Homogenous of Degree One.

…..>>>>

Free Trade with no Restrictions.

Zero Transportation Costs.

No Factor Intensity Reversal.

Full Employment.

Quantitative Difference in Factors but Qualitatively Homogenous.

Classification of Goods Based on Factor Intensity.

EXPLANATIONEXPLANATION

Difference in relative commodity prices is the immediate cause of international trade.

Difference in commodity prices is due to the difference in the factor prices.

Difference in factor prices is due to the difference in factor endowments.

Thus, good which uses more of abundant factor will be relatively cheap as relative factor price of abundant factor will be relatively low.

CRITERION OF FACTOR ABUNDANCECRITERION OF FACTOR ABUNDANCE

There are two criterion of classifying a country as labour/capital abundant or labour/capital scarce.

(i) Physical Criterion

(ii) Price Criterion

PHYSICAL CRITERIONPHYSICAL CRITERION

Based on the physical quantity.

The country whose capital-labour ratio is greater is called capital abundant.

Let us assume that Germany(G) and India(I) are two countries, then, Germany is capital abundant if:

Here, KG is quantity of capital in Germany and KI in India; LG is quantity of labour in Germany and LI in India.

KG KI

LG LI

DIAGRAMATIC EXPLANATIONDIAGRAMATIC EXPLANATION

Shape: Skewed Toward Y Axis.

Germany: Capital-Abundant Nation; Watches: Capital-Intensive;

India: Labour-Abundant

Shirts: Labour-Intensive

Shape: Skewed Toward X-Axis.

…>>>>

GERMANY

Y

X0 I1

I

Y

X0 I1

I

INDIA

WA

TC

HE

S

SHIRTS

GERMANYGERMANY

Y

I

I

Y

XO

INDIAINDIA

WA

TC

HE

S

SHIRTS

PIPI

PGPGG

RB

A

G1

If both countries produce in same ratio then Germany will produce at point ‘B’ and India at point ‘A’.

Ray ‘OR’ represents production of shirts and watches in same proportion.

Slope of Germany constraint line(PG) at point B is steeper then India's PI.

This shows that given factor endowments Germany can produce comparatively more watches and India more shirts.

Hence, India will export shirts and import watches from Germany.

The analysis in terms of physical quantity of factors of production consider supply aspect only.

…>>>>

It shows that capital-abundant country Germany has a bias in favour of capital-intensive commodity watches and labour abundant India in labour intensive shirts.

It does not show that the capital-abundant country will export capital-intensive commodity. It depends on the nature of demand.

To understand this we have to consider price criterion of factor abundance.

PRICE CRITERIONPRICE CRITERION

Based on the prices of factors of production.

The country where capital is relatively cheap is called capital abundant even if quantity of capital is relatively more.

Let us assume that Germany(G) and India(I) are two countries, then, Germany is capital abundant if:

PK is price of capital; PL is price of labour

GERMANY INDIA PK PK

PL PL

SS and WW iso-product curves for both countries.

DIAGRAMMATIC EXPLANATIONDIAGRAMMATIC EXPLANATION

AB and A1B1 are iso-cost line for Germany.

PQ and P1Q1 are iso-cost line for Germany.

A

B

P

Q

P1

Q1X

Y

O

LABOURLABOUR

CA

PIT

AL

S 100 Shirts

W 25 Watches

S

W

E

25 Watches

100 Shirts

B1

A1

Slope of iso-cost lines AB and PQ shows that capital is relatively cheap in Germany and labour is relatively cheap in India.

The iso-product curves crosses only at point ‘E’ Indicating no factor intensity reversal.

A

B

A

B

P

Q

P

Q

P1

Q1

P1

Q1X

Y

O

LABOURLABOUR

CA

PIT

AL

S 100 Shirts

W 25 Watches

S

W

E

25 Watches

100 ShirtsX

Y

O

LABOURLABOUR

CA

PIT

AL

S 100 Shirts

W 25 Watches

S

W

E

25 Watches

100 ShirtsX

Y

O

LABOURLABOUR

CA

PIT

AL

CA

PIT

AL

S 100 Shirts

W 25 Watches

S

W

E

25 Watches

100 Shirts

B1

A1

B1

A1

FOR GERMANY:

Production Cost of 25 Watches = ‘GH’ Capital + ‘FH’ Labour

Production Cost of 100 Shirts = ‘GH’ Capital + ‘FJ’ Labour

This shows that production cost of 100 shirts is more than 25 watches by ‘JH’(FJ-JH) amount of labour. ……(i)E

S 100 Shirts

S 100 Shirts

W 25 Watches

W 25 Watches

O X

Y

LABOURLABOUR

CA

PIT

AL

E

S 100 Shirts

S 100 Shirts

W 25 Watches

W 25 Watches

O X

Y

LABOURLABOUR

CA

PIT

AL

LABOURLABOUR

CA

PIT

AL

CA

PIT

AL

A1

B1B

A

F HJ

IG

P

QQ1

P1 E

S100 Shirts

S100 Shirts

W25 Watches

W25 Watches

O X

Y

K

L

M

NT

LABOURLABOUR

CAPITAL

FOR INDIA:

Production Cost of 25 Watches = ‘TL’ Labour + ‘KM’ Capital

Production Cost of 100 Shirts = ‘TL’ LABOUR + ‘LM’ Labour

This shows that production cost of 100 shirts is less than 25 watches by ‘KL’(KM-LM) amount of capital. ……(ii)

From (i) and (ii) we can conclude that as labour-abundant India can produce labour-intensive shirts at relatively lesser cost, it would specialise in the production of shirts and should export it.

Likewise, Germany should produce and export watches.

FACTOR PRICE EUALITYFACTOR PRICE EUALITY

When two countries start trading, then the factor prices will be equal in the long-run.

Because India will produce more of labour intensive shirts, hence demand for labour and wage rate will rise in India.

And as Germany import labour intensive goods, its demand for labour and wage rate will decline, till wage rate in both countries equalise.

COMPARISION BETWEEN CLASSICAL & MODREN THEORY

Modern theory: 2x2x2 model.

H-O explains the Causes.

Based on money cost.

Classical theory give importance to labour alone.

Considers inter-national trade as a special case of inter-regional trade.

Classical ignored factor endowment.…>>>>

Classical theory describes advantages of trade whereas modern theory its basis.

Classical theory assumes different production function whereas modern theory assumes same production function.

Modern theory forecast factor price equality.

CRITICISM 2x2x2 model

Leontief’s paradox.

Static theory.

No constant tastes.

Factors are not homogeneous.

Production techniques are not homogeneous.

Wrong argument of goods prices.

Partial equilibrium analysis.

IMPORTANT QUESTIONS

1. Critically examine modern theory of international trade.

2. Explain factor endowment. Give Ohlin arguments about its importance in explaining international trade.

3. Explain price criterion of factor abundance.

4. Write short notes on:

(I) Factor Price Equality;(Ii) Leontief Paradox;(Iii) Factor Intensity Reversal.

REFERENCES

M.L. Jhingan, “International Economics” Konark Publication, New Delhi.

T.R. Jain, O.P. Khanna & Vir Sen, “Development and Environmental Economics and International Trade” V.K. Publications, New Delhi.

B.O. Soderston “International Economics” Macmillan, London.

Steven M. Suranovic, “ International Trade Theory and Policy” at http://internationalecon.com/Trade/ Tch60/T60-0.php