Factor Proportion Theory

It may be pointed out at the outset that the Heckscher-Ohlin theory does not invalidate the classical theory of comparative costs, but rather powerfully supplement it, since it also accepts comparative advantage as the cause of international trade. However, the new theory succeeds where the classical theory fails in answering the question why after all is there a difference in comparative costs among countries? The classical two country two commodity and one factor model was incapable of finishing a satisfactory answer to this question. The answer is given by Eli Heckscher and Bertil Ohlin with an exposition of territorial specialization and trade in terms of the modern value theory, in place of the traditional labor theory of value of comparative costs thus the major contribution of Heckscher-Ohlin approach is to inquire more fundamentally into the ultimate basis of trade. Regarding the cause of trade, however, Heckscher Ohlin’s explanation aggresses with that of the classical school. But Heckscher Ohlin thiorm primarily seeks to explain what brings about the market difference in the comparative cost ratios as between prospective trading countries.

In fact, it was Heckscher who originated the idea that though comparative costs difference is the basic of international trade; the root cause is the condition which produces this difference. As a matter of fact the difference in comparative costs advantage assures because of (i) the difference in relative scarcity (and so relative price) of factors of production in the two countries, and the input of different factor proportions required in the production function of different commodities. The same thought was further elaborated by Prof. Ohlin. According to him also, the immediate cause of international trade is difference in commodity prices and difference in factor endowments cause factor prices to differ. (since factor prices are the ultimate costs of production costs and thus commodity prices will differ in different countries) that is to say the difference in factor internalities in the production function of commodities together with equal difference in relative factor of endowments of the countries caused the comparative costs difference in goods produced internationally which set the base of international trade.

It is an undisputed fact that regions are very differently endowed with facilities for the production of various goods as they are differently supplied with productive factors. In region A the supply of capital may be abundant but labour may be scarce. In region B the reverse may be the case. Thus in region A machines may be cheaper but wheat may be costlier. This will be so if capital is relatively cheaper due to its abundance while labour is costlier due to its relative scarcity and a greater proportion of capital is needed for producing machines. Similarly in region B because capital is scarce machines will be consoler while wheat will be cheaper labour being cheap and abundant. Tusk a different set of price will operate in both the regions for different goods depending on relative scarcity and thus relative factor prices. It appears, therefore that region A will possess a comparative cost advantage in the production of gods which employ more of the factors that are relatively abundant (and so cheap) in its. Similarly, region B will possess a comparative cost advantage in the produiotn of goods which employ more of the factors that are relatively abundant in it. It thus follows that region A will specialize in the production and export of goods (such as machines) which employ more of its relatively abundant and less to its relatively scarce factors and will import these goods (such as wheat ) which call for factors in the reverse proportion. The same will hold goods in region B also.

It follows that the relative price differences between two regions arise because of differences in the demand and supply conditions in both the regions. The relative commodity prices will however, be alike in the two regions under the following conditions.

(i) When demand and supply conditions for goods in both the regions are identical. It thus follows that wants, preferences, tastes habits incomes and other variants influencing demand position and pattern have unique two regions are also alike.

(ii) When demand and supply of factors of production are exactly balanced. Thus any difference in the factors supply is counterbalanced bay compensating difference in their demand.

These conditions are hardly fulfilled in the real world. Hence difference in relative factor supplies as well as in demand persist, leading to difference in relative factor price and hence in relative commodity prices between two regions. It should be noted that the difference in commodity prices arise as a result of difference in the supply of factors of production in two regions.

Comparison or factor prices in two regions with different currencies



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