Theory of the ratio of factors of production

In their theories of absolute and relative advantage, Smith and Ricardo showed how production can be increased if countries specialize in production that has an advantage. They accept that the functioning of the free market itself will lead producers to goods that they can produce with the greatest efficiency, and  will force them to abandon unprofitable industries.

About 125 years after the publication of the Smith and Ricardo theories, two Swedish economists, Eli Heckscher and Bertil Olin, developed the factor relation theory (also called the Heckscher-Ohlin theory), which states that each country exports those goods for the production of which it has relatively surplus factors of production, and imports those goods for the production of which it has a relative lack of factors of production.

The theory of the ratio of factors of production seems logical if you look at reviews of world production and exports. In countries with a high concentration of population, such as Hong Kong and the Netherlands, land prices are very high, so regardless of climate and soil condition, they do not have a developed production of goods that require large areas of land (sheep breeding, grain growing, etc.). These products are produced in countries such as Australia and Canada, where land is abundant in relation to population.

When labor resources are abundant in relation to capital, low wage rates and high export competitiveness of products that require large labor resources relative to the size of capital can be expected. The opposite can be expected with limited labor resources. Thus, India, Iran and Tunisia are distinguished by the developed production of handmade carpets, which differ in appearance and technology from carpets made in the UK and the USA with the help of machines purchased with cheap capital.

In the middle of the twentieth century (1948), American economists P. Samuelson and V. Stolper improved the Heckscher-Ohlin theory by introducing that in the case of homogeneity of factors of production, identity of technology, perfect competition and complete mobility of goods, international exchange equalizes the price of factors of production between countries. The authors base their concept on the model of D. Ricardo with the additions of Heckscher and Ohlin and consider trade not just as a mutually beneficial exchange, but also as a means to reduce the gap in the level of development between countries.

In the mid-50s of the twentieth century, the American economist V. Leontiev developed the theory of foreign trade in a work known as the “Leontiev paradox”.

Leontiev’s paradox states that the Heckscher-Ohlin theory of the ratio of factors of production is not confirmed in practice: labor-saturated countries export capital-intensive products, while capital-saturated ones export labor-intensive ones.

Using the Heckscher–Ohlin theorem, V. Leontiev showed that the American economy in the postwar period specialized in those types of production that required relatively more labor than capital. This contradicted pre-existing ideas about the US economy, which, due to the surplus of capital, would have to export mainly capital-intensive goods. By including in the analysis more than two factors of production, including NTP, differences in types of labor (skilled and unskilled) and their differentiated payment in different countries, V. Leontiev explained the above paradox and thereby contributed to the theory of comparative advantages.

Here are the main ideas that were put forward by V. Leontiev himself when explaining the paradox.

Leontiev’s first explanation is that there are differences in labor productivity between the United States and its trading partners (that is, labor in the United States contains more human capital, so it is more productive). The second explanation of V. Leontiev is that it is necessary to consider not only labor and capital, but also such an important element determining the models of trade as the endowment of the country with natural resources. (For example, importing crude oil, especially a capital-intensive commodity, in production requires the simultaneous use of both natural resources and capital.)

There are other attempts to explain the paradox discovered by V. Leontiev.

One of the most plausible explanations is that the Heckscher-Ohlin theory accepts the erroneous assumption that the factors of production are homogene. The skills of the labour force are actually very different within and across countries, as different people have different training and education. Training and education require capital investment, which does not manifest itself in traditional measures of capital, which include only the cost of structures and equipment. A change in the intensity of factors (as a theoretical possibility), for example, when the relative prices of labor and capital change over time. B.S. Minhas discovered this phenomenon in 1/3 of the six industries he studied. V. Leontiev in 1964 examined 21 industries and found confirmation of such a possibility only in 8% of cases. And when analyzing two industries that intensively use natural resources, he found confirmation of this hypothesis for only 1% of cases. The existence of trade barriers such as tariffs and quotas. (However, as you know, at that time the purpose of trade barriers was precisely to limit labor-intensive imports in order to preserve American jobs, which contradicts the revealed pattern) R.I. Boldvin (1971), on the basis of a study of US trade data in 1962, also confirmed that trade barriers cannot fully explain Leontiev’s paradox.

With some modification of the Heckscher-Ohlin theory in order to take into account the various groups of labor power and the capital invested in the professional training of these groups, the theory of the ratio of factors of production remains valid. If we look at labor not as a homogeneous commodity, but divide it into categories, we will find that industrialized countries actually have a significant surplus of highly educated labor resources (in which large investments have been made) compared to labor of other types. For example, the exports of industrialized countries reflect a higher proportion of professionals, such as scientists and engineers, so that these countries use their surplus factors of production. The exports of less developed countries are characterized by a high labor intensity of less skilled labor.

Over time, other attempts were made to explain the paradox, but it was never possible to fully explain it. This cast doubt on the uniqueness of the world trade model based on the Heckscher-Ohlin theory, which stimulated the development of modern theories of international trade.

Having considered the classical theories of international trade, we note that their common weakness is numerous limitations and assumptions. Therefore, economists of the twentieth century search for new theories that explain various aspects of international trade, based on classical theories, developing or refuting them.

Schematically, the development of classical theories can be represented as follows:

Figure 1.

Scheme of evolution of classical theories of international trade.

A review of theoretical explanations for the international exchange of goods given in Table 2 shows that traditional foreign trade theories are insufficient to explain the modern international exchange of goods, but nevertheless they are basic in the theoretical studies of scientists and explain the emergence and direction of international trade in goods by comparative advantages due to commodity differentiation and differences in sets of factors of individual countries.

Table 2.

Basic theories of international exchange of goods.

The further development of the theory of comparative advantages and new theories of internationalization is based on the inclusion in the research process of additional new factors and variables, including various human and capital resources of countries, NTP, conditions of imperfect market of goods and factors of production and international mobility of the latter, etc.