Theories of International Trade

Updated 13 September 2023

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Heckscher-Ohlin trade theory and the theories of comparative and absolute advantage are used by economists in understanding the dynamics around interaction of nations through exchange of goods and services. Arguments around benefits from financial and economic interdependence date as early as the mercantilist era. The interdependence influences the cultural, military and political relations of the nations involved. The three theories are widely utilized in international economics to explain how the exchange of capital, services and goods between countries can either be of benefit to the respective economies or put them at a disadvantage. This essay entails a discussion on how the Heckscher-Ohlin trade theory articulates with the theories of absolute and comparative advantage. Heckscher-Ohlin theorem was developed to help economists fill gaps in the theories of absolute and comparative advantage. It articulates with the theories by explaining reasons and causes for relative commodity prices and comparative advantage between two trading countries. The essay also analyses the consequences of Heckscher-Ohlin trade theory as a theoretical framing device for determination and analysis of global trade patterns. Discussion of theories under international trade requires reference to countries with different levels of productivity to help readers understand how the concepts apply to contemporary international relations. In the course of the discussion, the writer will elaborate their responses with specific reference to four countries: United States, China, Kenya and Yemen. These countries are classified by the World Bank under high-income, upper-middle-income, lower-middle-income and low-income respectively.

Definition of key terms

Bilateral trade: exchange of goods and services between two nations based on trade deals between the governments (Smith 1817, p. 243). This form of trade entails elimination or limitation of barriers to free trade such as tariffs and quotas to encourage free flow of trade and investment.

General equilibrium analysis: an attempt to explain the relationship between demand supply and prices in the global market (Jones 1956, p. 3).

How The Heckscher-Ohlin Trade Theory Articulate with The Theories of Comparative and Absolute Advantage

Heckscher-Ohlin trade theory was developed by Bertil Ohlin, who built on the work of Eli Heckscher, his tutor. Ohlin has been credited as the advocate of the modern theory of international trade (Caves, 1960, p. 5). He drew his ideas from the General Equilibrium Analysis that was introduced by his tutor. Heckscher-Ohlin trade theory states that countries export commodities that are manufactured from their abundant factors while importing goods that are manufactured using the resources that are considered scarce (Jones 1956, p. 1). Heckscher-Ohlin model is built on the assumption that the production process in a country is characterized by low relative costs for factors that are in abundance compared to other countries where the factors are relatively scarce. Heckscher’s General Equilibrium Analysis revealed that a nation’s comparative advantage comes with production of commodities that use factors that are relatively abundant (Zhu and Trefler 2005, p. 8). Some of the key assumptions made under Heckscher-Ohlin theory include same levels of technology and lack of government interference in trading nations (Jones 1965, p. 13). The proponents of the theory also assumed that the tastes and preferences of the markets in trading countries are equal (Bajona and Kehoe, 2010, p. 788). They also made an assumption that there exists free trade in exchange of both the factors and the final commodities. The Heckscher-Ohlin trade theory is valid in situations where the trade between the nations under question is balanced; meaning that the net value of a nation’s imports should be equal to the value of its exports (Davis et al. 1995, p. 202).

In the book Principles of Political Economy, David Ricardo stated that a nation will export commodities in which it has a competitive advantage while importing goods that gives it a competitive disadvantage (Ricardo 1891, p. 111). A competitive advantage develops from the ability of a nation to produce a commodity at a relatively lower domestic opportunity cost compared to its trading partner (Caves 1960, p. 23). Therefore, the nation will specialize in producing goods with a lower opportunity cost than another country that the former anticipates to trade with (Zhu and Trefler 2005, p. 3). David Ricardo prepones that trade can be of mutual benefit even in circumstances where one nation is more efficient than its trading partner. When concluding the book, Ricardo noted that trade is of benefit to partnering nations if there exists a significant difference in the comparative costs of the two nations (Ricardo 1891, p. 124). However, there are instances when a nation is more productive than another in all lines of production. Ricardo notes that even in circumstances where there are gaps in general productivity of trading partners, trade can be beneficial if the country’s trading partner is not equally less productive in all lines of production (Smith 1817, p. 126). The trading partner that is less productive should specialize in lines of production with the least difference in productivity relative to the former (Davis et al. 1995, p. 203). The issue of relativity in production comes up in both Heckscher-Ohlin trade theory and Ricardo’s theory of competitive advantage. Heckscher-Ohlin theory makes a comparison of countries based on availability of factors (Zhu and Trefler 2005, p. 4). Ricardo analyzes the opportunity cost of the trading nations. He explained that production process that require less quantities of the most abundant factor has the least opportunity cost (Caves, 1960, p. 9). Therefore, the abundant factors should be put towards production of a commodity that takes up the least proportion of the factors per unit output (Ricardo 1891, p. 113). According to Heckscher-Ohlin trade theory, availability of factors of production has a direct impact on their prices (Ito, Rotunno and Vézina, 2017, p. 430). A commodity whose production materials are cheaper comes with a lower opportunity cost because it takes up the least cost per unit output (van Meerhaeghe 2013, p. 23; Bajona and Kehoe, 2010, p. 800). Inputs are cheaper in scenarios where they are found in abundance (Smith 1817, p. 243). Therefore, countries specialize in production of commodities that utilize their abundant factors of production (Jones 1956, p. 1).

China has dominated the global steel market for decades. The World Bank categorizes the US as a high-income while China is considered as an upper-middle-income nation (The World Bank Group 2018, n.p; Tao Yang and Zhou 1999, p. 107). Therefore, the assumption made is that the efficiency in production is generally higher in the US compared to China. However, trade between the two countries has been beneficial to both nations because China, which mercantilists would have considered as being the loser in the trade, has placed more focus on production and exports of goods that use its abundant factors (Davis et al. 1995, p. 212). The trading partnership between the US and China resonates with the ideas of both Heckscher-Ohlin trade theory and David Ricardo’s theory of comparative advantage. In this essay, the writer makes reference to trade in steel and agricultural products between the two countries. China ‘s specialization in steel can be justified by examining both its comparative advantage in the commodity in relation to the US and also exploitation of iron ore as one of its abundant factors of production. The volume of agricultural exports from the US to China can be justified through an analysis of America’s competitive advantage in agricultural production in relation to China and exploitation of land as one of the abundant factors of production available in the US (Chaney 2008, p. 1780). Iron ore is the main input into production of steel while land is the major factor in agricultural production. The Heckscher-Ohlin trade theory articulates with the theory of absolute advantage in providing an explanation on how both China and the US benefit from trade in the steel and farm produce despite the two nations having differences in levels of productivity.

The US has slowly changed from a net exporter of steel to a net importer over the past five decades. China has vast deposits of iron ore, the main input into steel production. The industrial revolution was characterized by heavy exploitation of mineral resources in the US. Therefore, iron ore deposits in the US have shrunk (Tilton 2010, P. 13). Currently, about one-fifth of US imports to China are made up of agricultural products. Land is the main input in agriculture. According to the U.S. Census Bureau (2015), about 63% of the US population (62.7 %) lives in urban areas. The June 2017 estimates showed that the US had 326 million people. US cities only make up 3.5% of the total land area. Therefore, two-thirds of the population lives in 96.5% of the rest of the land. The total size of arable land in the US is 174.5 million hectares. The June 2017 estimates showed that China had 1.41 billion people. 56 percent of the population of China lives in Urban areas. The total size of arable land in China is 103.4 million hectares. Therefore, there is greater pressure on Arable land in China (Central Intelligence Agency 2018, n.p). Land is in abundant supply in the US. This makes agricultural production cheaper in the US compared to China where land is limited in supply. It becomes more advantageous for the US to produce and export to China. US farmers ship produce worth about $1 billion to other countries (Farm Credit Administration Office of Regulatory Policy 2018, p. 1). China imported agricultural goods worth $18.6 in 2017, the second largest after Canada. Data by the International Trade Administration (2018, p. 2) shows that US steel imports have grown rapidly since 2009. China’s position in the US steel trade has grown rapidly from 25 in 2016 to 10 in 2017. China is among the 10 countries that supply a total of 77% of steel used in the US. Local production supplies slightly less than one quarter of the total amount of steel used in the country. The analysis of two of the major commodities exchanged, steel and agricultural products indicates that the position of the two goods can be accounted for using both Heckscher-Ohlin trade theory and David Ricardo’s theory of comparative advantage.

The theory of absolute advantage was first discussed by Adam Smith in the 18th

century. Smith existed at a time when mercantilism was the most dominant economic system (Smith 1817, p. 240). Mercantilists believed that wealth was static and it should be accumulated at the national level (van Meerhaeghe 2013, p. 13). The mercantilists felt that a country that takes part in bilateral and multilateral trade has to give up some of its wealth in exchange for other goods, services or capital from other nations (Jones 1965, p. 562). To mercantilists, both countries involved in trade cannot benefit concurrently from the dealings. Through the theory of absolute advantage, Smith sought to prove the mercantilists wrong. He refuted the claim that the gain of one nation was a result of a loss of the other (Smith 1817, p. 237). Adam Smith’s major argument was that voluntary trade was a positive-sum game; meaning that both nations can gain from bilateral trade (Smith 1817, p. 243).

The World Bank Group (2017) categorize China as an upper-middle-income country while Yemen is a lower-middle-income country. China is Yemen’s second-largest trade partner. In the first quarter of 2018, Yemen’s exports to China totalled to $2.17 million while the imports were $1.9 million, accounting for a partner share of over 10% (World Integrated Trade Solution 2018, n.p). Yemen has large oil deposits that have aided in keeping its economy afloat despite political instability. China’s industrial dominance has resulted in a huge demand for oil. China’s annual crude petroleum production is estimated at 1300 million barrels annually. The country’s heavy industries cannot be sustained by this production. In 2017, China’s demand for oil was double its production. Therefore, the country imported 50% of the oil consumed locally. China has maintained good relations with countries in the Arabian Gulf with the aim of benefitting from their oil exports while maintaining market for locally produced goods. Yemen’s main imports from China are made up of chemicals and machinery.

According to Heckscher-Ohlin trade theory of international trade, a nation exports commodities whose production utilizes its abundant factors (Jones 1956, p. 1; Ito, Rotunno and Vézina, 2017, p. 430). The Chinese population grew rapidly from the 1950s. Subsequently, the country invested heavily in education as a way of promoting growth of semi-skilled and skilled labour. Therefore, China is a labour-abundant country (Tao Yang and Zhou 199, p. 106). Production of machinery is labour-intensive. Yemen has experienced political instability since obtaining its independence from Britain in the 1960s. The country’s population has grown at a relatively slower rate than most nations. Education and training have been largely interfered with by war and conflict. Therefore, the country’s labour is not as abundant and developed as China’s. Therefore, in applying the Heckscher-Ohlin theorem, China is best placed to benefit from trade with Yemen if the former exports goods that use labour, its abundant factor (Tao Yang and Zhou 1999, p. 109).. Oil is a natural resource whose production mainly depends on natural oil reserves. By the end of 2017, China’s proven amounts totalled to 25,620 million barrels 9.597 million kilometres squared. Yemen’s proven oil reserves contained a total of 3000 million barrels 0.5 million kilometres squared. One can compare the abundance of oil reserves in the two countries by considering both the capacity of the proven oil reserves and the total land area of the two countries. China’s deposits can be presented as 2770 barrels per kilometre square while Yemen’s deposits are 6000 barrels per kilometre square (World Energy Council 201, n.p.). Therefore, oil is an abundant factor in Yemen and the country stands to gain if it exports crude oil to China. According to Adam Smith’s theory of absolute advantage, trade is beneficial to a nation if it is a least cost producer in its exports (Smith 1817, p. 243). The absolute difference in costs exists for China and Yemen in machinery and crude oil production respectively. Instead of committing its abundant labour towards production of crude oil, China puts it in production of a labour-intensive good like machinery (Tao Yang and Zhou 1999, p. 109). Yemen lacks the labour to put towards production of machinery. The country therefore invests in production of crude oil which is less labour intensive but requires oil deposits which are an abundant factor. According to Heckscher-Ohlin theorem, a country will experience relatively lower cost for a factor that is in relative abundance (Bajona and Kehoe, 2010, p. 460; Chaney 2008, p. 1723). Due to large populations and subsequently supply of labour, Chinese manufacturers enjoy low costs of labour inputs. Labour costs in China have gone low in the recent past to an extent of escalating to an ethical issue (Tao Yang and Zhou 1999, p. 117). Therefore, Heckscher-Ohlin’s theorem explains why China has put more emphasis on manufacturing machinery. Oil deposits are a relatively abundant factor in Yemen and the entire Gulf Region. Therefore, obtaining land where the deposits are found for exploitation is associated with a relatively lower cost in Yemen compared to China (World Integrated Trade Solution 2018, n.p). Both Heckscher-Ohlin articulates the theory of absolute advantage by explaining the link between the abundant factor and its exploitation for goods to be exchanged in bilateral trade.

Consequences of Heckscher-Ohlin as A Theoretical Framing Device in Relation to Determining the Patterns of Trade Globally

According to Heckscher-Ohlin theorem, comparative advantage of a country lies in production of goods that use factors that are relatively abundant in relation to trading partners (Jones 1956, p. 1). When using Heckscher-Ohlin theory as a theoretical framing device, one has to consider both the abundant factors in the trading countries and their intensity in production of the relevant trading commodities (Ito et al., 2017, p. 430). The concept of factor abundance is complex since the Heckscher-Ohlin theorem entails an assumption that production of commodities in both countries is synonymous, i.e., the intensiveness of production factors required is similar (van Meerhaeghe 2013, p. 24). This theoretical framing becomes invalid when dealing with different income categories. The income categories are an indicator of the level of technology employed in production. The horticultural sector is one of the few ones where developing countries and underdeveloped countries have dominated (Williams, 2007, p .1). However, these countries have had to put up with stiff competition from Holland. Holland is a high-income country while Kenya is a lower-middle-income country (The World Bank Group 2018 n.p). Both nations are some of the leading producers of cut flowers in the world. However, Kenya exports a significant percentage of its flowers to Netherlands. Horticultural production in Netherlands is mechanized, an indicator that it is capital-intensive (Williams, 2007, p. 7). Kenya’s flower production process is relatively less mechanized than Holland. Large flower farms require more workers per production unit, meaning that production is labour-intensive (Williams 2007, p. 3). This scenario does not fulfil the assumption under Heckscher-Ohlin that technology is the same in trading nations and that commodities require similar proportions of various inputs in both trading nations (Ito, Rotunno and Vézina, 2017, p. 428).

The Heckscher-Ohlin model entails establishment of an equilibrium between trade partners (Jones 1965, p. 3). The. Economic analysts consider supply of factors, advancement of technology, tastes and preferences, how factors of production are distributed and the final demand of commodities in both countries (Bajona and Kehoe 2010, p. 461; Chaney 2008, p. 1722). Though the decisions made on the basis of these considerations have been implemented in the past, the analysts have a hard time convincing leaders who are responsible for establishment of bilateral trade links with other nations.

The rationale of the argument under Heckscher-Ohlin theoretical framework was founded on barter trade (Zhu and Trefler 2005, p. 8). The theoretical framework is relevant where two countries exchange two goods between themselves. In the contemporary world, the state is no longer a very active primary participant in trade. Transactions in international trade are carried out at the firm level (Chaney 2008, p. 1712). The state creates an enabling environment through means such as bilateral deals that do away with duties and taxes. The nations’ traders then take advantage of such relationships to export and import goods at profits (Davis 1995, p. 218; Caves, 1960, p. 15). The international financial system allows countries to export their goods to one country in exchange for money and obtaining what they need from another partner (van Meerhaeghe 2013, p. 18). The restrictive nature of the Heckscher-Ohlin theory means that it cannot be used in explaining scenarios where a country’s export trade volume with another is different from its import trade volume (Bajona and Kehoe, 2010, p. 458). The assumption made in such a scenario is that the country that imports more loses.

The Heckscher-Ohlin theory focuses on the supply-side (Ito, Rotunno and Vézina, 2017, p. 428). Use of Heckscher-Ohlin theorem as a theoretical framing draws the attention of the economists and key decision-makers towards the supply side (Zhu and Trefler 2005, p. 8; Caves, 1960, p. 35). However, demand is an equally important factor in determination of global patterns of trade. There are instances where demand is a more significant force. In the case of the floral sectors of Kenya and the Netherlands the former has a very low demand for flowers. In Kenya, the entire flower industry depends demand in other nations (Williams 2007, p. 3). On the contrary, a significant percentage of Netherland’s floral products are consumed locally. Therefore, Kenya can export some of its flowers to Netherlands to compete for market with what is produced locally (Williams, 2007, p.1). Most developed countries produce vehicles locally. However, they export vehicles to each other and allow them to compete with what is manufactured locally. The US Internal Trade Administration (2015) has data on volumes of imports and export for light trucks, passenger vehicles, medium and heavy duty trucks. This is an indicator that the country imports and exports machinery. Such patterns in global trade cannot be justified using the Heckscher-Ohlin theorem.

Using the Heckscher-Ohlin as a theoretical framing device in relation to determining the patterns of trade globally gives economists a wrong perception of the relationship pricing of factors and commodities (Ito, Rotunno and Vézina, 2017, p. 436). Wijnhold criticized the Heckscher-Ohlin theorem on the basis of the assumption that commodity costs and prices are determined by the factor prices (van Meerhaeghe 2013, p. 23). In applying the law of demand and supply, commodity prices have a major impact on factor prices (Smith 1817, p. 231). Factors are priced on the basis of the amount of money that the final buyers of products are willing to offer for them. The demand and pricing of final commodities is influenced by other factors such as the existence and cost of substitutes (Davis et al. 1995, p. 218). In the case of the trade between Yemen and China for instance, the price of Yemen’s crude oil is influenced by energy alternatives available to commercial and domestic consumers in China. In this scenario, the extent of benefit enjoyed by Yemen in its trade with China is not entirely dependent on its macroeconomic factors.

Conclusion

Heckscher-Ohlin’s trade theory was formulated by Eli Heckscher and Bertil Ohlin to predict patterns in world trade based on abundant factors of production in various regions. The theory is used in explaining the causes of differences in the comparative advantage and relative commodity prices between two trading nations. According to Adam Smith’s theory of absolute advantage, a country makes bilateral trade beneficial by finding a good where its production costs are lower than that of its partner. David Ricardo’s comparative advantage theory states that trade is beneficial to a country where it exports a commodity that it produces at a lower opportunity cost than its partner. Heckscher-Ohlin trade theory provides an explanation on how international is beneficial in instances where a country specializes in producing and exporting goods that use its abundant factors intensively. According to the theorem, abundant factors of production are cheaper due to their large supply. As a result, a country should specialize in producing commodities that use these factors. Heckscher and Ohlin’s argument resonates with Smith’s idea that a country should specialize in goods whose production costs are lower. By producing the good at a cheaper cost, the country foregoes the production of commodities that use its scarce resources, which would have been expensive from Heckscher and Ohlin’s argument. Therefore, the goods that use the relatively abundant factors are associated with lower opportunity costs. However, Heckscher-Ohlin model fails to account for many real-life scenarios in global trade, such as situations where countries produce similar goods and exchange them. It ignores the role of demand forces in price determination. Therefore, trading patterns determined on the basis of the model can result in cases where countries make losses despite specializing in production and export of goods that use their abundant factors.

References

Bajona, C. and Kehoe, T.J., 2010. Trade, growth, and convergence in a dynamic Heckscher–Ohlin model. Review of Economic Dynamics, 13(3), pp.487-513. [Online]Available at: [Accessed September 27, 2018]

Caves, R.E., 1960. Trade and economic structure: Models and methods (No. 115). Harvard University Press. [Online]Available at: [Accessed September 27, 2018]

Central Intelligence Agency. 2018. Field Listing: Land Use. https://www.cia.gov/library/publications/the-world-factbook/fields/2097.html > [Accessed September 27, 2018]

Chaney, T., 2008. Distorted gravity: the intensive and extensive margins of international trade. American Economic Review, 98(4), pp.1707-21. https://www.tse- [Online]Available at: