How Does Demand Reversal Invalidates the Theory of Hecksher-Ohlin Theorem

The modern theory of international trade Figure 1. 1 DEMAND REVERSAL Country A produces at point A, specializing in the production of steel, it consumes at point D, given the utility pattern represented by the indifference curve (IC a). This means that country A exports EA amount and import ED amount of steel. Therefore country A which is a capital surplus country is exporting labour intensive goods (cloth) and importing capital intensive goods (steel). This is in direct conflict with the HECKSCHER OHLIN prediction concerning the commodity structure of trade.

Likewise, country B specializes in the production of cloth, but it consumes at point G in response to its utility pattern represented by the indifference (IC b). Therefore it exports BF amount of steel and imports FG amount of cloth. Once again we notice that country B, which is a labour surplus country exports capital intensive goods (steel) and imports labour intensive goods (cloth). The HECKSCHER OHLIN prediction is overturned. In this case, represented in figure 1. 1 we have a situation of what is called demand reversal.

Here not only the two biases-consumption and production are in the same direction but also the consumption bias more than offsets the production bias. Consumption point D lies to the left of production point A in country A and in country B the consumption point G lies to the right of production point B. When such a demand reversal takes place, the capital surplus country would export labour intensive goods. The HECKSCHER OHLIN theory would then be invalidated by the demand reversal Critical evaluation of the HECKSCHER OHLIN theorem

In the area of pure theory of international trade, the HECKSCHER OHLIN model occupies a very prestigious position. The very fact that many known Economists like Leontief, Walters, Minhas and others have tried to test the empirical validity of the HECKSCHER OHLIN theorem using econometric models, stands as a testimony of the prestige of the model. The HECKSCHER OHLIN theorem has been criticised mainly along the following lines: the factor intensity reversal, Leontief and paradox and demand reversal argument Factor intensity argument The HECKSCHER OHLIN theorem was based on the assumption that the production unctions are different for different goods but they are identical for each good in two countries. This, in other words means that one good is capital intensive and the other good is labour intensive, but the same good which is capital intensive in one country, must be capital intensive in the other country also and the labour intensive good remains labour intensive in both the countries. This assumption is guaranteed when both the two production isoquants for capital intensive and labour intensive cut each other only once but not more than once in diagram 1 this is shown to happen at point Q.

The demonstration in diagram 1 is consistant with the HECKSCHER OHLIN assumption of non-reversability of factor intensities. If factor intensity reversal takes place, then two isoquants will cut each other more than once and the HECKSCHER OHLIN theorem would turn out to be invalid this case is demonstrated in the following diagram. The two production isoquants for steel and cloth cut each other twice in the succeeding diagram: once at point A and the second time at point B. The factor price ratios in country A(capital surplus country) are represented by the parallel lines P 0 P 0.

P 1 P 1 represent the factor price ratios in country B(Labour surplus country). In the above diagram note the following factors: in country A steel is labour intensive. In order to produce one unit of either steel or cloth, country A has to use the same amount of capital but more labour for steel than cloth. Cloth has a higher capital-labour ratio and steel has a lower capital-labour ratio. Therefore, a capital rich country like country A would specialize in the production and export of the capital intensive goods, which is cloth.

It would import steel which is a labour intensive good. In Country B, cloth is a labour intensive good and steel is a capital intensive good. Because, to produce one unit of cloth it takes a given amount of labour and smaller amount of capital as compared to steel. Steel takes the same amount of labour but more capital per unit of output. In country B, therefore, steel has a higher capital –labour ratio than in cloth. Naturally country B (labour surplus country), would choose to specialize in the production and exports of the labour intensive goods, cloth.

Country B therefore would export cloth and import steel which is capital intensive. In this case of factor intensity reversal, as we say above both the countries produce and export the same commodity i. e. cloth. In the capital rich country (country A) it is a capital intensive product and in the labour rich country (country B) it is a labour intensive product. That means the same product (cloth) is capital intensive in one country but less intensive in another country. The same thing applies to steel as well. Steel is labour intensive product in the capital rich country (country B).

This is a situation of a factor intensity reversal. When this takes place, both countries end up producing and exporting the same commodities (cloth) and importing the other commodity (steel). This would invalidate the Heckscher Ohlin prediction regarding the structure of commodity trade. In the above diagram the two isoquants cut each other more than once, suggesting factory intensity reversal to the left of point A and to the right of point B. For factor intensities to reverse themselves, it is not, however necessary that the two isoquants cut each other more than once.

Leontief and paradox The first comprehensive and detailed examination of the Heckscher Ohlin theorem was the one undertaken by Leontief. You will recall that the theory of factor proportions predicted that the capital abundant country exported capital intensive goods and imported labour intensive goods, and the labour surplus country did the opposite. It is commonly agreed that the USA is a capital rich and labour scarce country. Therefore one would expect exports to consist of capital intensive goods and imports to consist of labour intensive goods.

Leontief made an extensively study of the USA and the results were startling, in contrast to what the Heckscher Ohlin theory predicted, Leontief`s study showed that the USA exports consisted of labour intensive goods and imports consisted of capital intensive goods. In Leontief`s own words” Americas participation in division of labour in international trade is based on its specialization in labour intensive rather than capital intensive lines of production. In other words the country resorts to foreign trade in order to economize its capital and dispose its surplus labour rather than vice versa.

Leontief`s findings are summarized in the following table Exportsimports Capital in US $ in 1947 prices2. 550. 7803. 091. 339 Labour (man years)1. 80. 3131. 70. 004 Capital-labour ratio( US $ per man hour)13. 91118. 185 From the above table, it is obvious that the US exports had a lower capital-labour ratio that these are import replacement produced in the US as opposed to the actually imported goods of the country. Leontief`s paradox results stimulated similar studies for other countries


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