Heckscher–Ohlin model
It builds on David Ricardo's theory of comparative advantage by predicting patterns of commerce and production based on the resources of a trading region.
[1] Relative endowments of the factors of production (land, labor, and capital) determine a country's comparative advantage.
Countries have comparative advantages in those goods for which the required factors of production are relatively abundant locally.
Thus, this theory aims to explain the scheme of international trade that we observe in the world economy.
This demonstrates why the United States has been a large importer of these Chinese products since it does not abound in cheap labor.
While still building on traditional models such as the Ricardian framework, the mid 1900s bring forth innovation in international trade theory with the introduction of the Heckscher-Ohlin (H-O) model, developed by Swedish economists Eli Heckscher and Bertil Ohlin from the Stockholm School of Economics.
Ricardo considered a single factor of production (labour) and would not have been able to produce comparative advantage without technological differences between countries (all nations would become autarkic at various stages of growth, with no reason to trade with each other).
With international variations in the capital endowment like infrastructure and goods requiring different factor "proportions", Ricardo's comparative advantage emerges as a profit-maximizing solution of capitalist's choices from within the model's equations.
With this single difference, Ohlin was able to discuss the new mechanism of comparative advantage, using just two goods and two technologies to produce them.
These developments did not change the fundamental role of variable factor proportions in driving international trade, but added to the model various real-world considerations (such as tariffs) in the hopes of increasing the model's predictive power, or as a mathematical way of discussing macroeconomic policy options.
Countries have natural advantages in the production of various commodities in relation to one another, so this is an "unrealistic" simplification designed to highlight the effect of variable factors.
This meant that the original H–O model produced an alternative explanation for free trade to Ricardo's, rather than a complementary one; in reality, both effects may occur due to differences in technology and factor abundances.
In addition to natural advantages in the production of one sort of output over another (wine vs. rice, say) the infrastructure, education, culture, and "know-how" of countries differ so dramatically that the idea of identical technologies is a theoretical notion.
It is further assumed that capital can shift easily into either technology, so that the industrial mix can change without adjustment costs between the two types of production.
This condition is more defensible as a description of the modern world than the assumption that capital is confined to a single country.
The 2x2x2 model originally placed no barriers to trade, had no tariffs, and no exchange controls (capital was immobile, but repatriation of foreign sales was costless).
In Ohlin's day this assumption was a fairly neutral simplification, but economic changes and econometric research since the 1950s have shown that the local prices of goods tend to correlate with incomes when both are converted at money prices (though this is less true with traded commodities).
Neither labor nor capital has the power to affect prices or factor rates by constraining supply; a state of perfect competition exists.
Neither the rental return to capital, nor the wage rates seem to consistently converge between trading partners at different levels of development.
This is done by dividing the nominal rates with a price index, but took thirty years to develop completely because of the theoretical complexity involved.
Heckscher and Ohlin considered the Factor-Price Equalization theorem an econometric success because the large volume of international trade in the late 19th and early 20th centuries coincided with the convergence of commodity and factor prices worldwide.
Modern econometric estimates have shown the model to perform poorly, however, and adjustments have been suggested, most importantly the assumption that technology is not the same everywhere.
The results of Bowen, Leamer, and Sveiskaus (1987) mean that the Heckscher–Ohlin–Vanek (HOV) theory has no predictive power concerning the direction of trade.
Once trade is allowed, profit-seeking firms move their products to the markets that have (temporary) higher prices.
Daniel Trefler and Susan Chun Zhu summarizes their paper that "It is hard to believe that factor endowments theory [editor's note: in other words, Heckscher–Ohlin–Vanek Model] could offer an adequate explanation of international trade patterns".
In fact, Davis and others found that HOV model fitted extremely well with the regional data of Japan.
Heckscher–Ohlin theory excludes unemployment by the very formulation of the model, in which all factors (including labour) are employed in the production.
The factor price equalization theorem has not shown a sign of realization, even for a long time lag of a half century.
Ricardian theory is now extended in a general form to include not only labor, but also inputs of materials and intermediate goods.
In this sense, it is much more general and plausible than the Heckscher–Ohlin model and escapes the logical problems such as capital as endowments, which is, in reality, produced goods.
