Factor Endowment Theory: Meaning, Assumptions, and Criticisms

Heckscher-Ohlin’s Factor Endowment Theory

Heckscher-Ohlin’s Factor Endowment Theory also called Heckscher-Ohlin Model, H-O Model, Factor Endowment Theory, and Factor Proportion Theory is an economic as well as international trade theory that states that a nation should produce and export products for which factors of production the country is rich.

Factor endowment refers to the richness, abundance, and easy availability of factors of production (namely land, labor, and capital) to the country. This theory argues that a country that has relatively large labor forces should concentrate on production through labor-intensive means. And, a country that has relatively more capital should go for production through capital-intensive means.

Swedish economists, Eli Heckscher in 1919 and Bertil Ohlin in 1933 put forward different explanations of Ricardo’s comparative cost advantage theory. So, called the H-O Model. The H-O model explains what causes differences in the comparative cost of different countries.

The theory holds that factors in relative abundance are cheaper than factors in relative scarcity. It explains the basis of international trade in terms of factor endowments. Factor endowment refers to how many factors of production a country has been endowed with by Mother Nature.

If labor, for example, were abundant in comparison to land and capital, labor costs would be low relative to land and capital costs (i.e., rent and interests respectively). If labor were scarce, labor costs would obviously be high against land and capital costs. These relative factors costs would lead countries to excel (do better) in the production and also exports, which have used their cheaper, abundant factors of production.

According to the H-O model, “variances in the supply of production components produce international and interregional differences in production cost.” Comparative advantage originates from variations in national factor endowments, according to Heckscher and Ohlin, and while free trade is advantageous, the pattern of trade is regulated by differences in factor endowments rather than productivity disparities.

According to factor endowment, countries export products requiring large amounts of their abundant production factors and import products requiring large amounts of their scarce production factors.

By this H-O model, trade or international trade takes place because production costs occur due to the differences in the supply of production factors. For example, China, India, Nepal, Bangladesh, etc. can export labor-oriented products because labor resources are abundant in these countries.

Countries like Japan, the USA, the UK, and Germany are exporting capital-oriented products like machinery, high-value equipment, etc. as they pose the abundant (endowment) of having high capital investment required for technology and other facilities.

Assumptions of the H-O Model

The main assumptions of the H-O model can be mentioned below.

  • Different goods have different factor intensities – for example, textile and clothing are labor-intensive goods and a semi-conductor is a capital-intensive product.
  • Countries differ with respect to their factor endowments – for example, Nepal has an abundant supply of labor goods relative to capital, whereas the USA has an abundant supply of capital goods relative to labor.
  • Two countries, two goods, and two factors of production.
  • Perfect competition in commodities and factor markets.
  • Constant returns to factors.
  • Given technology is universally available.
  • There are no transport costs, insurance premiums, or exchanges.
  • No control of trade and exchange rates.
  • Factors immobility between countries and factors endowments.
  • Demand conditions are fixed.

Criticisms of Factor Endowment Theory

Factor endowment theory of international trade may be criticized in the following points.

Static Nature of Inputs is Wrong

In terms of new technologies, the H-O model assumes a constant supply of factor endowments. New technologies and breakthroughs, on the other hand, can be used to produce endowments.

Superior technology and abilities that lower the cost of production could also be drivers of trade. A practical and high-quality educational system can also improve the quality of human resources.

Wrong Assumption of Homogeneous Products and Consumers’ Taste

For theory, factor endowment homogeneous products and the same tastes were the assumptions. The difference in taste is also a basis of trade, where even the price factor is neglected.

In the case of some products transportation charges, handling costs and tariffs together are higher than the cost of the product itself. However, people are ready to pay such costs because of taste preferences.

For example, Swiss Cottage Cheese, French wines and perfumes, German beer, etc. are preferred in many parts of the world, and trades on these products take place not because of price factors but because of differences in tastes.

Assumption of Non-Existence of Money and Absence of Transportation Costs

This theory assumes there is no existence of money and transportation costs. With the introduction of money, traders could know if it was profitable to buy locally or to import by the means of exchange rates, converting foreign currency to home currency.

Therefore, with the introduction of money and exchange rate traders could judge the profitability.

Other Factors are Avoided

Economies of scale and the experience curve also affect international trade as these permit a nation’s industry to become a low-cost producer without having an abundance of certain factors.

When a plant grows, output increases and unit production cost decreases the fact that – large and efficient equipment is used, it gets volume discounts on bulk procurement of inputs, R&D and overhead cost decrease, and it also learns the technique to decrease the cost.

The Leontief Paradox

In short, the Leontief paradox means the actions against the principle of factor endowment theory. As this theory states a nation’s abundance of labor should export labor-intensive products and import capital-intensive ones. And, a nation’s abundance in capital factors should export capital-intensive goods and import labor-intensive ones. But, the Leontief paradox is the just opposite of it.

Wassily Leontief, the US Economist, criticized the H-O Model when his study was completed in 1953. It was well believed that the US has a relatively abundant capital supply compared to labor in other countries. And the US would be an exporter of capital-intensive goods and an importer of labor-intensive goods.

He found the cases where the US was exporting highly labor and skill intensive products in exchange for capital intensive products also. Therefore, the finding was at variance with the philosophy of the H-O Model, and his finding was named “The Lenotief Paradox”.

Because of the strong incentives for R&D developed countries like the US, Germany, and Japan produced many innovative consumer products and also cost-saving processes. They also exported many products all over the world. The majority of export products were not capital-intensive products. On the other hand, these developed countries also imported or exchanged many capital-intensive items like machinery, computers, etc. from Taiwan, Poland, and China, etc.

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