Question

Explain the factor proportions theory and discuss why it has contradictions with the new trade theory. Discuss with examples.

Answer 1

Factor Proportion Theory famously known as the Heckscher Ohlin Model or HO Model is a trade theory which explains international trade on the basis of "comparative advantage". It believes that one reason that countries differ is in endowment of factors of production. This is the reason trade may arise between countries with different allocation of resources of production.

This model considers 2 factors of production, that is, Labour and Capital. The country having factor abundance in any one will export the goods which uses that factor intensively. Factor abundance can be explained in terms of endowment in resource or factor prices. Eg: A country is labour abundant if ratio of labour to capital available in that country is more than that in the trading country. Or alternatively, a country is also said to be labour abundant if wages relative to cost of capital is less on that country as compared to the trading country.

Further, the model assumes 2 goods, one which uses labour intensively say cloth and other that uses capital intensively say steel. The trade between countries will be such that the country which is abundant in labour will export cloth which is labour intensive to the other country because of it's comparative advantage. This country in turn will import steel from its trading partner which is capital abundant.

The New Trade Theory on the other hand believes that "economies of scale" have a major role to play in determining patterns of trade. Economies of scale may be so much of a factor that they may outweigh comparative advantage and effect patterns of trade. For eg: if a country is very labour abundant and it starts production of labour intensive good like cloth at a smal scale because the country is not very rich to install large plants. But, there's another country which is not labour abundant but it installs a cloth plant at a very large scale. The economies of scale due to sheer size of the plant brings the cost of production so down that it becomes cheaper for the 2nd country to export cloth in bulk, despite not having comparative advantage in it.

Another aspect to this model is that of early entrants. The Industrial Revolution gave a headstart to Europe in heavy industries which helped them reduce their cost of production as they went down the learning curve and bettered their technology. This however, prevented countries that are actually endowed with mineral deposits to become competitive because they were just starting off.

Thus, this is the primary contradiction between the 2 theories. One believes that trade is because of comparative advantage while the other believes that economies of scale and early start can overpower comparative advantage.

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