The modern theory of international trade was given by two Swedish economists named Eli Heckscher and Bertil Ohlin. Unlike the classical theories of trade the Heckscher – Ohlin theory shows us why cost differences occur between 2 regions. This theory is also called as the Factor Endowment theory. The theory agrees with comparative cost theory given by David Ricardo, however it states that the difference in cost arises due to 2 reasons:-
The Regions Factor Endowments
The Factor Proportions
The theory states that countries produce those commodities of which they have abundant factor. This means that capital rich economies produce capital intensive goods while labour rich countries produce labour intensive goods.
The model has 2 countries, two commodities and two factors.
There is full employment.
There is no transportation cost.
Perfect competition exists in both product and factor markets.
There is free trade.
The H- O theory can be understood in terms of factor abundance and factor intensity.
Factor Abundance: –
The theory states that the differences in factor endowments lead to trade between two countries. This means some countries will have labour in abundance and some countries will have capital in abundance. The abundance in if factors can be shown through the following criterion:-
K1÷L1 > K2÷L2
The above criterion tells us that if the ratio of capital to labour in country 1 is greater than the ration of capital to labour in country 2 than we deduce that country 1 is capital abundant. This criterion is called as the physical criterion.
PK1÷PL1 > PK2÷PL2
.i.e. the price of capital to labour ratio is greater for country 1 to that of country 2 then we say that country 1 is capital abundant. This criterion is called as the physical criterion.