Why trade?

The Heckscher-Ohlin theory explains why countries trade goods and services with each other. One condition for trade between two countries is that the countries differ with respect to the availability of the factors of production. They differ if one country, for example, has many machines (capital) but few workers, while another country has a lot of workers but few machines. According to the Heckscher-Ohlin theory, a country specializes in the production of goods that it is particularly suited to produce. Countries in which capital is abundant and workers are few, therefore, specialize in production of goods that, in particular, require capital. Specialization in production and trade between countries generates, according to this theory, a higher standard-of-living for the countries involved.

What is an economic theory?

One can compare an economic theory with a map of a piece of land. A map gives an idea of what a certain piece of land looks like, even though nature is too complex to be described completely by it. While a map can help us understand an unknown terrain, economic theories help us understand economic interactions between individuals or countries. For example, why individuals or countries trade with each other and why trade may benefit the parties involved.

Machines and Workers

The production of goods and services requires capital and workers. Some goods require more capital - technical equipment and machinery - and are called capital intensive. Examples of these goods are cars, computers and cell phones. Other goods require less equipment to produce and rely mostly on the efforts of the workers. These goods are called labor intensive. Examples of these goods are shoes and textile products such as jeans.

Gains from Trade

By specializing in production, and by trading with other countries, it is possible for countries to increase their incomes. Even though countries as a whole benefit from specialization and international trade, all groups in society, workers and capitalists, do not gain according to the Heckscher-Ohlin theory. If international trade leads a country to specialize in producing goods that require lots of workers and little capital, such a specialization increases wages (which benefits the workers) but decreases the income of the capital owners. But the country as a whole benefits because the gain of the workers is bigger than the loss of the capital owners.

The Heckscher-Ohlin Trade Theory

The Heckscher-Ohlin theory says that two countries trade goods with each other (and thereby achieve greater economic welfare), if the following assumptions hold.

o  The major factors of production, namely labor and capital, are not available in the same proportion in both countries.

o   The two goods produced either require relatively more capital or relatively more labor.

o   Labor and capital do not move between the two countries.

o   There are no costs associated with transporting the goods between countries.

o   The citizens of the two trading countries have the same needs.

Bigger Differences -- Greater Gains

Of the conditions discussed previously, the central one is the assumption that capital and labor are not available in the same proportion in the two countries. This condition leads to specialization. The country with relatively more capital specializes -- but not necessarily fully -- in production of capital-intensive goods (which it exports in exchange for labor-intensive goods) while the country with relatively little capital specializes in production of labor-intensive goods (which it exports in exchange for capital-intensive goods).

According to the theory, the more different the countries are -- regarding the capital-to-labor ratio -- the greater the economic gain from specialization and trade.

Example:

Imagine two countries that each produce both jeans and cell phones. Although both countries use the same production technologies, one has a lot of capital but a limited number of workers, while the other country has little capital but lots of workers.

The country that has a lot of capital but few workers can produce many cell phones but few pairs of jeans because cell phones are capital intensive and jeans are labor intensive. The country with many workers but little capital, on the other hand, can produce many pairs of jeans but few cell phones.

According to the Heckscher-Ohlin theory, trade makes it possible for each country to specialize. Each country exports the product the country is most suited to produce in exchange for products it is less suited to produce. The country that has a lot of capital specializes in the production of cell phones, whereas the country that has more labor specializes in the production of jeans.

In this case, neither country has specialized in producing more of one of the two particular products -- both countries produce about the same number of jeans and cell phones.

Country A -- having more capital than labor -- has specialized in producing more cell phones. Country B -- having more labor than capital -- has specialized in producing more jeans. In this case, trade may benefit both countries involved.