HeckscherOhlin model

The HeckscherOhlin model (HO model) is a general

equilibrium mathematical model of international trade, developed
by Eli Heckscher and Bertil Ohlin at the Stockholm School of
Economics. It builds on David Ricardo's theory of comparative
advantage by predicting patterns of commerce and production
based on the factor endowments of a trading region. The model
essentially says that countries will export products that use their
abundant and cheap factor(s) of production and import products
that use the countries' scarce factor(s).

Features of the model

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. This
is because the profitability of goods is determined by input costs.
Goods that require inputs that are locally abundant will be cheaper
to produce than those goods that require inputs that are locally
scarce.
For example, a country where capital and land are abundant but
labor is scarce will have comparative advantage in goods that
require lots of capital and land, but little laborgrains. If capital
and land are abundant, their prices will be low. As they are the
main factors used in the production of grain, the price of grain will
also be lowand thus attractive for both local consumption and
export. Labor-intensive goods on the other hand will be very
expensive to produce since labor is scarce and its price is high.
Therefore, the country is better off importing those goods.

Theoretical development
The Ricardian model of comparative advantage has trade
ultimately motivated by differences in labour productivity using
different "technologies". Heckscher and Ohlin did not require
production technology to vary between countries, so (in the
interests of simplicity) the "HO model has identical production
technology everywhere". 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). The HO model

removed technology variations but introduced variable capital

endowments, recreating endogenously the inter-country variation
of labour productivity that Ricardo had imposed exogenously. 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. The decision
that capital owners are faced with is between investments in
differing production technologies; the HO model assumes capital
is privately held.

222 model
The original HO model assumed that the only difference between
countries was the relative abundances of labor and capital. The
original HeckscherOhlin model contained two countries, and had
two commodities that could be produced. Since there are two
(homogeneous) factors of production this model is sometimes
called the "222 model".
The model has "variable factor proportions" between countries
highly developed countries have a comparatively high capital-tolabor ratio compared to developing countries. This makes the
developed country capital-abundant relative to the developing
country, and the developing nation labor-abundant in relation to
the developed country.
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. One technology would be a
capital-intensive industry, the other a labor-intensive business
see "assumptions" below.

Theoretical assumptions
The original, 222 model was derived with restrictive
assumptions, partly for the sake of mathematical simplicity. Some
of these have been relaxed for the sake of development. These
assumptions and developments are listed here.

Both countries have identical production technology

This assumption means that producing the same output of either
commodity could be done with the same level of capital and labour
in either country. Actually, it would be inefficient to use the same
balance in either country (because of the relative availability of
either input factor) but, in principle this would be possible. Another
way of saying this is that the per-capita productivity is the same in

both countries in the same technology with identical amounts of

capital.
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 HO 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. Ohlin said that the HO model was a long-run model, and
that the conditions of industrial production are "everywhere the
same" in the long run.

Production output is assumed to exhibit constant

returns to scale
In a simple model, both countries produces two commodities. Each
commodities in turn is made using two factors of production. The
production of each commodities requires input from both factors of
productioncapital (K) and labor (L). The technologies of each
commodities is assumed to exhibit constant returns to scale
(CRS). CRS technologies implies that when inputs of both capital
and labor is multiplied by a factor of k, the output also multiplies by
a factor of k. For example, if both capital and labor inputs are
doubled, output of the commodities doubled. In other terms
production function of both commodities is "homogeneous of
degree 1".
The assumption of constant returns to scale CRS is useful
because it exhibits a diminishing returns in a factor. Under
constant returns to scale, doubling both capital and labor leads to
a doubling of the output. Since outputs are increasing in both
factors of production, doubling capital while holding labor constant
leads to less than doubling of an output. Diminishing returns to
capital and diminishing returns to labor are crucial to the Stolper
Samuelson theorem.

The technologies used to produce the two

commodities differ

The CRS production functions must differ to make trade

worthwhile in this model. For instance if the functions are Cobb
Douglas technologies the parameters applied to the inputs must
vary. An example would be:
Arable industry:
Fishing industry:
Where A is the output in arable production, F is the output in fish
production, and K, L are capital and labor in both cases.
In this example, the marginal return to an extra unit of capital is
higher in the fishing industry, assuming units of fish (F) and arable
output (A) have equal value. The more capital-abundant country
may gain by developing its fishing fleet at the expense of its arable
farms. Conversely, the workers available in the relatively laborabundant country can be employed relatively more efficiently in
arable farming.

Factor mobility within countries

Within countries, capital and labor can be reinvested and
reemployed in order to produce different outputs. Similar to
Ricardo's comparative advantage argument, this is assumed to
happen without cost. If the two production technologies are the
arable industry and the fishing industry it is assumed that farmers
can shift to work as fishermen with no cost and vice versa.
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. For
instance, if the two industries are farming and fishing it is assumed
that farms can be sold to pay for the construction of fishing boats
with no transaction costs.
The theory by Avsar has offered much criticism to this.

Factor immobility between countries

The basic HeckscherOhlin model depends upon the relative
availability of capital and labor differing internationally, but if capital
can be freely invested anywhere competition (for investment) will
make relative abundances identical throughout the world.
Essentially, free trade in capital would provide a single worldwide
investment pool.
Differences in labour abundance would not produce a difference in
relative factor abundance (in relation to mobile capital) because
the labour/capital ratio would be identical everywhere. (A large

country would receive twice as much investment as a small one,

for instance, maximizing capitalist's return on investment).
As capital controls are reduced, the modern world has begun to
look a lot less like the world modelled by Heckscher and Ohlin. It
has been argued that capital mobility undermines the case for free
trade itself, see: Capital mobility and comparative advantage Free
trade critique.
Capital is mobile when:
There are limited exchange controls
Foreign direct investment (FDI) is permitted between countries,
or foreigners are permitted to invest in the commercial
operations of a country through a stock or corporate bond
market
Like capital, labor movements are not permitted in the Heckscher
Ohlin world, since this would drive an equalization of relative
abundances of the two production factors, just as in the case of
capital immobility. This condition is more defensible as a
description of the modern world than the assumption that capital is
confined to a single country.

Commodity prices are the same everywhere

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). It was also free of
transportation costs between the countries, or any other savings
that would favor procuring a local supply.
If the two countries have separate currencies, this does not affect
the model in any waypurchasing power parity applies. Since
there are no transaction costs or currency issues the law of one
price applies to both commodities, and consumers in either country
pay exactly the same price for either good.
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 be correlated
with incomes when both are converted at money prices (although
this is less true with traded commodities). See: Penn effect.

Perfect internal competition

Neither labor nor capital has the power to affect prices or factor
rates by constraining supply; a state of perfect competition exists.

Conclusions
The results of this work has been the formulation of certain named
conclusions arising from the assumptions inherent in the model.

HeckscherOhlin theorem
The exports of a capital-abundant country will be from capitalintensive industries, and labour-abundant countries will import
such goods, exporting labour-intensive goods in return.
Competitive pressures within the HO model produce this
prediction fairly straightforwardly. Conveniently, this is an easily