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.

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 \(C_2\). 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 that the existence of two goods with different compositions of factors. Our first good, X, requires more capital to produce when we compare it to Y, which requires more labor to produce.

Now let us assume that one country, \(C_1\), has a capital endowment and the other country, \(C_2\), has a labor endowment. We can illustrate their endowments with the following notation.

\(\dfrac{K_{C_1}}{L_{C_1}} > \dfrac{K_{C_2}}{L_{C_2}} \)

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.

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

• There exist two countries where they are trading with each other.

• There are two goods to be traded, one good requires more capital to produce, and the other good requires more labor to produce.

• One country has a labor endowment, and the other country has a capital endowment.

• Factors of production are immobile between countries and mobile within countries.

• Both of these countries share the same technological structure and the same taste in consumption.

Heckscher Ohlin Model Graph

Heckscher-Ohlin's model is easy to demonstrate with a graph. Let us assume that there exist two countries, \(C_1\) and \(C_2\). \(C_1\) is capital endowed. Similarly, let’s assume that there exist two goods, \(X\) and \(Y\). \(X\) is a capital-intensive good and \(Y\) is a labor-intensive good. If there are two factors of production, labor and capital, then we can say that \(C_1\) will produce \(X\) relatively cheaper to \(C_2\) since it is capital endowed. We can illustrate their production possibilities frontier as follows.

Fig.1 - Production possibilities frontier 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 \(C_1\) is skewed towards the capital-intensive good, X. Similarly, \(C_2\) is labor endowed, and its production possibilities frontier is skewed towards \(Y\) since \(Y\) is a labor-intensive commodity.

Points A and B, in the first figure, represent the relative prices of goods, \(X\) and \(Y\), in autarky (economic independence). But what will happen after the trade? To understand this, let’s state that the differences in prices of two goods depend on the demand and supply of the goods. Since \(C_1\) is capital endowed, the production of the capital-intensive commodity, \(X\), will be much more than \(C_2\). Therefore, relative prices of these goods will be accordingly.

\((\dfrac{P_X}{P_Y})_{C_1} < (\dfrac{P_X}{P_Y})_{C_2}\)

This is rather reasonable since the first country will produce more capital-intensive commodities relative to the second country. Therefore, the price of the \(X\) will be lower in the first country relative to the second country.

After a trade, the supply rates will change, and every country will export the commodity in which they have more abundance in its factors. For example, let us illustrate the relative prices in the first country, \(C_2\), as follows.

Fig. 2 - The budget line of the second country after the trade

The relative prices of the good before the trade can be represented with \(\dfrac{Y_1}{X_2}\) where the budget line, \(C’_1\), is tangent to the production possibilities frontier at point A. Nonetheless, after the export of the good \(Y\), the relative prices will increase, and the new budget line, \(C’_2\), will be tangent to the production possibilities frontier at point B where the relative price is \(\dfrac{Y_2}{X_1}\).

Heckscher Ohlin Model 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.

Heckscher Ohlin Model Criticism

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 can not 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.