The document discusses the Heckscher-Ohlin theory of international trade, which explains that differences in factor endowments between countries leads to comparative advantage and trade. Specifically, countries will export goods that intensively use their relatively abundant and cheaper factors of production, and import goods that intensively use their scarce and expensive factors. This theory analyzes trade patterns based on differences in capital-labor ratios and resulting factor prices between capital-abundant and labor-abundant nations.

1. MODERN THEORY OF INTERNATIONAL
TRADE (HECKSCHER-OHLIN THEORY)
Dr. Laxmi Narayan
Assistant Professor Economics
Govt. P.G. College, Mahendergarh
E-mail: laxmi_narayan70@yahoo.com

2. STATEMENT
Examines the basis of comparative
advantage.
Difference in relative factor endowments
and factor price is main reason for
difference in comparative advantage.
A nation will export the commodity in the
production of which a relatively large
amount of its abundant and cheap
resource is used and vice-versa.

3. ASSUMPTIONS
 2x2x2 Model.
 Factor Mobility.
 Prefect Competition.
 Identical Demand.
 Production Function.
- Identical;
- No Change;
- Linear Homogenous of Degree One.
…..>>>>

4.  Free Trade with no Restrictions.
 Zero Transportation Costs.
 No Factor Intensity Reversal.
 Full Employment.
 Quantitative Difference in Factors but
Qualitatively Homogenous.
 Classification of Goods Based on Factor
Intensity.

5. EXPLANATION
Difference in relative commodity prices is the
immediate cause of international trade.
Difference in commodity prices is due to the
difference in the factor prices.
Difference in factor prices is due to the
difference in factor endowments.
Thus, good which uses more of abundant factor
will be relatively cheap as relative factor price of
abundant factor will be relatively low.

6. CRITERION OF FACTOR ABUNDANCE
There are two criterion of classifying a country
as labour/capital abundant or labour/capital
scarce.
(i) Physical Criterion
(ii) Price Criterion

7. PHYSICAL CRITERION
Based on the physical quantity.
The country whose capital-labour ratio is
greater is called capital abundant.
Let us assume that Germany(G) and India(I)
are two countries, then, Germany is capital
abundant if:
Here, KG is quantity of capital in Germany
and KI in India; LG is quantity of labour in
Germany and LI in India.
KG KI
LG LI

8. DIAGRAMATIC EXPLANATION
Shape: Skewed Toward Y Axis.
Germany: Capital-Abundant Nation;
Watches: Capital-Intensive;
India:
Labour-Abundant
Shirts:
Labour-Intensive
Shape: Skewed
Toward X-Axis.
…>>>>
GERMANY
Y
X0 I1
I
Y
X0 I1
I
INDIA
WATCHES
SHIRTS

9. GERMANYGERMANY
Y
I
I
Y
XO
INDIAINDIA
WATCHES
SHIRTS
PIPI
PGPGG
R
B
A
G1
If both countries produce in same ratio
then Germany will produce at point ‘B’
and India at point ‘A’.
Ray ‘OR’ represents production of shirts
and watches in same proportion.
Slope of Germany
constraint line(PG)
at point B is steeper
then India's PI.

10. This shows that given factor endowments
Germany can produce comparatively
more watches and India more shirts.
Hence, India will export shirts and import
watches from Germany.
The analysis in terms of physical
quantity of factors of production consider
supply aspect only.
…>>>>

11. It shows that capital-abundant country
Germany has a bias in favour of capital-
intensive commodity watches and labour
abundant India in labour intensive shirts.
It does not show that the capital-abundant
country will export capital-intensive
commodity. It depends on the nature of
demand.
To understand this we have to consider price
criterion of factor abundance.

12. PRICE CRITERION
 Based on the prices of factors of production.
 The country where capital is relatively cheap
is called capital abundant even if quantity of
capital is relatively more.
 Let us assume that Germany(G) and India(I)
are two countries, then, Germany is capital
abundant if:
PK is price of capital; PL is price of labour
GERMANY INDIA
PK PK
PL PL

13. SS and WW iso-product curves
for both countries.
DIAGRAMMATIC EXPLANATION
AB and A1B1 are iso-cost line
for Germany.
PQ and P1Q1 are iso-cost line
for Germany.
A
B
P
Q
P1
Q1
X
Y
O
LABOURLABOUR
CAPITAL
S 100 Shirts
W 25 Watches
S
W
E
25 Watches
100 Shirts
B1
A1

14. Slope of iso-cost lines AB
and PQ shows that capital
is relatively cheap in
Germany and labour is
relatively cheap in India.
The iso-product curves crosses only at point ‘E’
Indicating no factor intensity reversal.
A
B
A
B
P
Q
P
Q
P1
Q1
P1
Q1
X
Y
O
LABO URLABO UR
CAPITAL
S 100 Shirts
W 25 W atches
S
W
E
25 W atches
100 Shirts
X
Y
O
LABO URLABO UR
CAPITAL
S 100 Shirts
W 25 W atches
S
W
E
25 W atches
100 Shirts
X
Y
O
LABO URLABO UR
CAPITALCAPITAL
S 100 Shirts
W 25 W atches
S
W
E
25 W atches
100 Shirts
B1
A1
B1
A1

15. FOR GERMANY:
Production Cost of 25 Watches
= ‘GH’ Capital + ‘FH’ Labour
Production Cost of 100 Shirts
= ‘GH’ Capital + ‘FJ’ Labour
This shows that production
cost of 100 shirts is more than
25 watches by ‘JH’(FJ-JH)
amount of labour. ……(i)E
S 100 Shirts
S 100 Shirts
W 25 Watches
W 25 Watches
O
X
Y
LABOURLABOUR
CAPITAL
E
S 100 Shirts
S 100 Shirts
W 25 Watches
W 25 Watches
O
X
Y
LABOURLABOUR
CAPITAL
LABOURLABOUR
CAPITALCAPITAL
A1
B1B
A
F H
J
IG

16. P
QQ 1
P1 E
S 100 Shirts
S 100 Shirts
W 25 W atches
W 25 W atches
O
X
Y
K
L
M
N
T
CAPITAL
FOR INDIA:
Production Cost of 25 Watches
= ‘TL’ Labour + ‘KM’ Capital
Production Cost of 100 Shirts
= ‘TL’ LABOUR + ‘LM’ Labour
This shows that production
cost of 100 shirts is less than
25 watches by ‘KL’(KM-LM)
amount of capital. ……(ii)

17.  From (i) and (ii) we can conclude that as labour-
abundant India can produce labour-intensive
shirts at relatively lesser cost, it would
specialise in the production of shirts and should
export it.
 Likewise, Germany should produce and export
watches.

18. FACTOR PRICE EUALITY
 When two countries start trading, then the
factor prices will be equal in the long-run.
 Because India will produce more of labour
intensive shirts, hence demand for labour
and wage rate will rise in India.
 And as Germany import labour intensive
goods, its demand for labour and wage
rate will decline, till wage rate in both
countries equalise.

19. COMPARISION BETWEEN
CLASSICAL & MODREN THEORY
Modern theory: 2x2x2 model.
H-O explains the Causes.
Based on money cost.
Classical theory give importance to labour
alone.
Considers inter-national trade as a special
case of inter-regional trade.
Classical ignored factor endowment.
…>>>>

20. Classical theory describes advantages of
trade whereas modern theory its basis.
Classical theory assumes different
production function whereas modern
theory assumes same production function.
Modern theory forecast factor price
equality.

21. CRITICISM
 2x2x2 model
 Leontief’s paradox.
 Static theory.
 No constant tastes.
 Factors are not homogeneous.
 Production techniques are not
homogeneous.
 Wrong argument of goods prices.
 Partial equilibrium analysis.

22. IMPORTANT QUESTIONS
1. Critically examine modern theory of international
trade.
2. Explain factor endowment. Give Ohlin arguments
about its importance in explaining international
trade.
3. Explain price criterion of factor abundance.
4. Write short notes on:
(I) Factor Price Equality;
(Ii) Leontief Paradox;
(Iii) Factor Intensity Reversal.

23. REFERENCES
 M.L. Jhingan, “International Economics” Konark
Publication, New Delhi.
 T.R. Jain, O.P. Khanna & Vir Sen, “Development
and Environmental Economics and International
Trade” V.K. Publications, New Delhi.
 B.O. Soderston “International Economics”
Macmillan, London.
 Steven M. Suranovic, “ International Trade Theory
and Policy” at http://internationalecon.com/Trade/
Tch60/T60-0.php