Heckscher Ohlin Theory

The Heckscher Ohlin theory basically explains why nations trade goods and services with each other. One condition for trade between two countries is that the countries differ with respect to the availability of the factors of production. They differ if one country, for example, has many machines (capital) but few workers, while another country has a lot of workers but few machines. According to the Heckscher-Ohlin theory, a country specializes in the production of goods that it is particularly suited to produce. Countries in which capital is abundant and workers are few, therefore, specialize in production of goods that, in particular, require capital. Specialization in production and trade between countries generates, according to this theory, a higher standard-of-living for the countries involved. The Heckscher-Ohlin theory says that two countries trade goods with each other (and thereby achieve greater economic welfare), if the following assumptions hold:

• Labor and capital do not move between the two countries (there are no factor flows).
• Labor and capital, are not available in the same proportion in both countries.
• The two goods produced either require relatively more capital or relatively more labor.
• There are no costs associated with transporting the goods between countries.
• The citizens of the two trading countries have the same needs.

Of the above conditions, the central one is the assumption that capital and labor are not available in the same proportion in the two countries. This condition leads to specialization. The country with relatively more capital specializes - but not necessarily fully - in production of capital-intensive goods (which it exports in exchange for labor-intensive goods) while the country with relatively little capital specializes in production of labor-intensive goods (which it exports in exchange for capital-intensive goods). According to the theory, the more different the countries are - regarding the capital-to-labor ratio - the greater the economic gain from specialization and trade.