International Business Theories

International business comprises all commercial transactions (private and governmental, sales, investments, logistics, and transportation) that take place between two or more regions, countries and nations beyond their political boundaries.

A multinational enterprise (MNE) is a company that has a worldwide approach to markets and production or one with operations in several countries.Well-known MNEs include fast-food companies such as McDonald's and Yum Brands, vehicle manufacturers such as General Motors, Ford Motor Company and Toyota, consumer-electronics producers like Samsung, LG and Sony, and energy companies such as ExxonMobil, Shell and BP.

(Retrieved from https://en.wikipedia.org/wiki/International_business)

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Theories of International Business

1. Mercantilism

2. Absolute Advantage Theory

3. Comparative Advantage Theory

4. Heckscher-Ohlin Model

1. Mercantilism

Definition of 'Mercantilism':

The main economic system used during the sixteenth to eighteenth centuries. The main goal was to increase a nation's wealth by imposing government regulations concerning all of the nation's commercial interests. It was believed that national strength could be maximized by limiting imports via tariffs and maximizing exports.

Investopedia explains 'Mercantilism'

This approach assumes the wealth of a nation depends primarily on the possession of precious metals such as gold and silver. This type of system cannot be maintained forever, because the global economy would become stagnant if every country wanted to export and no one wanted to import.  

History

Some economic historians (like Peter Temin) argue that the economy of the Early Roman Empire was a market economy and one of the most advanced agricultural economies to have existed (in terms of productivity, urbanization and development of capital markets), comparable to the most advanced economies of the world before the Industrial Revolution, namely the economies of 18th century England and 17th century Netherlands. There were markets for every type of good, for land, for cargo ships; there was even an insurance market.

Many European economists between 1500 and 1750 are today generally considered mercantilists; however, these economists did not see themselves as contributing to a single economic ideology. The bulk of what is commonly called "mercantilist literature" appeared in the 1620s in Great Britain. Adam Smith, who was critical of the idea, was the first person to organize formally most of the contributions of mercantilists into what he called "the mercantile system" in his 1776 book The Wealth of Nations.

Beyond England, Italy, France, and Spain had noted writers who had mercantilist themes in their work, indeed the earliest examples of mercantilism are from outside of England: in Italy, Giovanni Botero (1544-1617) and Antonio Serra (1580-?), in France, Colbert and some other precursors to the physiocrats, in Spain, the School of Salamanca writers Francisco de Vitoria (1480 or 1483 – 1546), Domingo de Soto (1494-1560), Martin de Azpilcueta (1491 - 1586), and Luis de Molina (1535-1600).

Widespread Definition

Mercantilism is an economic theory that the prosperity of a nation depends upon its capital, and that the volume of the world economy and international trade is unchangeable. Government economic policy based on these ideas is also sometimes called mercantilism,

Economic assets, or capital, are represented by bullion (gold, silver, and trade value) held by the state, which is best increased through a positive balance of trade with other nations (exports minus imports). Mercantilism suggests that the ruling government should advance these goals by playing a protectionist role in the economy, by encouraging exports and discouraging imports, especially through the use of tariffs.

Features

Mercantilism is the economic doctrine that government control of foreign trade is of paramount importance for ensuring the military security of the country. In particular, it demands a positive balance of trade.

High tariffs, especially on manufactured goods, are an almost universal feature of mercantilist policy.

Other policies have included:

  • Building a network of overseas colonies;

  • Forbidding colonies to trade with other nations;

  • Monopolizing markets with staple ports;

  • Banning the export of gold and silver, even for payments;

  • Forbidding trade to be carried in foreign ships;

  • Export subsidies;

  • Promoting manufacturing with research or direct subsidies;

  • Limiting wages;

  • Maximizing the use of domestic resources;

  • Restricting domestic consumption with non-tariff barriers to trade.

Principles

Mercantilism contained many interlocking principles some of them as follows:

  1. Precious metals, such as gold and silver, were deemed indispensable to a nation’s wealth. If a nation did not possess mines or have access to them, precious metals should be obtained by trade. It was believed that trade balances must be “favorable,” meaning an excess of exports over imports. Colonial possessions should serve as markets for exports and as suppliers of raw materials to the mother country. Manufacturing was forbidden in colonies, and all commerce between colony and mother country was held to be a monopoly of the mother country.
  1. A strong nation, according to the theory, was to have a large population, for a large population would provide a supply of labor, a market, and soldiers. Human wants were to be minimized, especially for imported luxury goods, for they drained off precious foreign exchange. Sumptuary laws (affecting food and drugs) were to be passed to make sure that wants were held low.

Influence

Mercantilism as a whole cannot be considered a unified theory of economics because mercantilism has traditionally been driven more by the political and commercial interests of the State and security concerns than by abstract ideas. There were no mercantilist writers presenting an overarching scheme for the ideal economy, as Adam Smith would later do for classical (laissez-faire) economics. Some scholars thus reject the idea of mercantilism completely, arguing that it gives "a false unity to disparate events". Mercantilists viewed the economic system as a zero-sum game, in which any gain by one party required a loss by another. Thus, any system of policies that benefited one group would by definition harm the other, and there was no possibility of economics being used to maximize the "commonwealth", or the common good.

Mercantilist domestic policy was more fragmented than its trade policy. The early modern era was one of the letters patent and government-imposed monopolies; some mercantilists supported these, but others acknowledged the corruption and inefficiency of such systems. Many mercantilists also realized that the inevitable results of quotas and price ceilings were black markets. One notion mercantilists widely agreed upon was the need for economic oppression of the working population; laborers and farmers were to live at the "margins of subsistence". The goal was to maximize production, with no concern for consumption. Extra money, free time, or education for the "lower classes" was seen to inevitably lead to vice and laziness, and would result in harm to the economy.

Mercantilism developed at a time when the European economy was in transition. Isolated feudal estates were being replaced by centralized nation-states as the focus of power. Technological changes in shipping and the growth of urban centers led to a rapid increase in international trade. Mercantilism focused on how this trade could best aid the states. Another important change was the introduction of double-entry bookkeeping and modern accounting.

Prior to mercantilism, the most important economic work done in Europe was by the medieval scholastic theorists.  They focused mainly on microeconomics and local exchanges between individuals. This period saw the adoption of Niccol√≤ Machiavelli's realpolitik and the primacy of the raison d'√©tat in international relations. The mercantilist idea that all trade was a zero sum game, in which each side was trying to best the other in a ruthless competition, was integrated into the works of Thomas Hobbes. Note that non-zero sum games such as prisoner's dilemma can also be consistent with a mercantilist view. In prisoner's dilemma, players are rewarded for defecting against their opponents. More modern views of economic co-operation amidst ruthless competition can be seen in the folk theorem of game theory.

Criticisms

Adam Smith and David Hume are considered to be the founding fathers of anti-mercantilist thought. A number of scholars found important flaws with mercantilism long before Adam Smith developed an ideology that could fully replace it. Critics like Dudley North, John Locke, and David Hume undermined much of mercantilism.

Failure to understand other theory: Mercantilists failed to understand the notions of absolute advantage and comparative advantage (although this idea was only fully fleshed out in 1817 by David Ricardo) and the benefits of trade. In modern economic theory, trade is not a zero-sum game of cutthroat competition, because both sides can benefit (rather, it is an iterated prisoner's dilemma). By imposing mercantilist import restrictions and tariffs instead, both nations ended up poorer.

Impossibility to maintain trade balance: David Hume famously noted the impossibility of the mercantilists' goal of a constant positive balance of trade. As bullion flowed into one country, the supply would increase and the value of bullion in that state would steadily decline relative to other goods.  Eventually, it would no longer be cost-effective to export goods from the high-price country to the low-price country, and the balance of trade would reverse itself. Mercantilists fundamentally misunderstood this, long arguing that an increase in the money supply simply meant that everyone gets richer.

Importance of bullion: The importance placed on bullion was also a central target, even if many mercantilists had themselves begun to de-emphasize the importance of gold and silver. Adam Smith noted that at the core of the mercantile system was the "popular folly of confusing wealth with money," bullion was just the same as any other commodity, and there was no reason to give it special treatment.

Rent-seeking critique: The critique that mercantilism was a form of rent-seeking has also seen criticism, as scholars such Jacob Viner in the 1930s point out that merchant mercantilists such as Mun understood that they would not gain by higher prices for English wares abroad.

Inheritance

In the English-speaking world, Adam Smith's utter repudiation of mercantilism was accepted, eventually, as public policy in the British Empire and in the United States. Initially, it was rejected in the United States by such prominent figures as Alexander Hamilton, Henry Clay, Henry Charles Carey, and Abraham Lincoln and in Britain by such figures as Thomas Malthus.

In the 20th century, most economists on both sides of the Atlantic have come to accept that in some areas mercantilism had been correct. Most prominently, the economist John Maynard Keynes explicitly supported some of the tenets of mercantilism. Adam Smith had rejected focusing on the money supply, arguing that goods, population, and institutions were the real causes of prosperity. These views later became the basis of monetarism, whose proponents actually reject much of Keynesian monetary theory, and has developed as one of the most important modern schools of economics.

Adam Smith rejected the mercantilist focus on production, arguing that consumption was the only way to grow an economy. Keynes argued that encouraging production was just as important as consumption. In an era before paper money, an increase in bullion was one of the few ways to increase the money supply. Keynes and other economists of the period also realized that the balance of payments is an important concern, and since the 1930s, all nations have closely monitored the inflow and outflow of capital, and most economists agree that a favorable balance of trade is desirable. Keynes also adopted the essential idea of mercantilism that government intervention in the economy is a necessity. Today the word remains a pejorative term, often used to attack various forms of protectionism. The similarities between Keynesianism, and its successor ideas, with mercantilism, have sometimes led critics to call them neo-mercantilism.

One area Smith was reversed on well before Keynes was that of the use of data. Mercantilists, who were generally merchants or government officials, gathered vast amounts of trade data and used it considerably in their research and writing. William Petty, a strong mercantilist, is generally credited with being the first to use empirical analysis to study the economy.

2. Absolute Advantage Theory

In economics, the principle of absolute advantage refers to the ability of a party (an individual, or firm, or country) to produce more of a good or service than competitors, using the same amount of resources. Adam Smith first described the principle of absolute advantage in the context of international trade, using labor as the only input.

Definition of 'Absolute Advantage'

The ability of a country, individual, company or region to produce a good or service at a lower cost per unit than the cost at which any other entity produces that good or service.

Investopedia explains 'Absolute Advantage'

Entities with absolute advantages can produce something using a smaller number of inputs than another party producing the same product. As such, absolute advantage can reduce costs and boost profits.

Since absolute advantage is determined by a simple comparison of labor productivities, it is possible for a party to have no absolute advantage in anything;[7] in that case, according to the theory of absolute advantage, no trade will occur with the other party.[8] It can be contrasted with the concept of comparative advantage which refers to the ability to produce a particular good at a lower opportunity cost.

Origin of the theory

The main concept of absolute advantage is generally attributed to Adam Smith for his 1776 publication An Inquiry into the Nature and Causes of the Wealth of Nations in which he countered mercantilist ideas. Smith argued that it was impossible for all nations to become rich simultaneously by following mercantilism because the export of one nation is another nation’s import and instead stated that all nations would gain simultaneously if they practiced free trade and specialized in accordance with their absolute advantage.

Features of this theory:

A country that has an absolute advantage produces a greater output of a good or service than other countries using the same amount of resources. Smith stated that tariffs and quotas should not restrict international trade; it should be allowed to flow according to market forces. Contrary to mercantilism Smith argued that a country should concentrate on the production of goods in which it holds an absolute advantage. No country would then need to produce all the goods it consumed. The theory of absolute advantage destroys the mercantilist idea that international trade is a zero-sum game. According to the absolute advantage theory, international trade is a positive-sum game, because there are gains for both countries to an exchange.

Condition:

The theory is that trade occurs when one country, individual, company, or region is absolutely more productive than another entity in the production of a good. A person, company or country has an absolute advantage if its output per unit of input of all goods and services produced is higher than that of another entity producing that good or service.

Problems of Absolute Advantage:

There is a potential problem with absolute advantage. If there is one country that does not have an absolute advantage in the production of any product, will there still be benefits to trading, and will trade even occur? The answer may be found in the extension of absolute advantage, the theory of comparative advantage.

Example

The principle was described by Adam Smith in the context of international trade. Now I am describing some of them below:

A country has an absolute advantage over another in producing a good, if it can produce that good using fewer resources than another country. For example, if one unit of labor in India can produce 80 units of wool or 20 units of wine; while in Spain one unit of labor makes 50 units of wool or 75 units of wine, then India has an absolute advantage in producing wool and Spain has an absolute advantage in producing wine. India can get more wine with its labor by specializing in wool and trading the wool for Spanish wine, while Spain can benefit by trading wine for wool. (Adam Smith, Wealth of Nations, Book IV, Ch.2.) The benefits to nations from trading are the same as to individuals: trade permits specialization, which allows resources to be used more productively.

3. Comparative Advantage Theory

Definition of 'Comparative Advantage'

The ability of a firm or individual to produce goods and/or services at a lower opportunity cost than other firms or individuals. A comparative advantage gives a company the ability to sell goods and services at a lower price than its competitors and realize stronger sales margins.

Investopedia explains 'Comparative Advantage'

Having a comparative advantage - or disadvantage - can shape a company's entire focus. For example, if a cruise company found that it had a comparative advantage over a similar company, due to its closer proximity to a port, it might encourage the latter to focus on other, more productive, aspects of the country.

Origins of the theory

The idea of comparative advantage has been first mentioned in Adam Smith's book The Wealth of Nations: "If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage." But the law of comparative advantages has been formulated by David Ricardo who investigated in detail advantages and alternative or relative opportunity in his 1817 book On the Principles of Political Economy and Taxation in an example involving England and Portugal.

Ricardo's Theory of Comparative Advantage

David Ricardo stated a theory that other things being equal a country tends to specialize in and exports those commodities in the production of which it has maximum comparative cost advantage or minimum comparative disadvantage. Similarly, the country's imports will be of goods having relatively less comparative cost advantage or greater disadvantage.

Ricardo's Assumptions:-

Ricardo explains his theory with the help of following assumptions:-

  1. There are two countries and two commodities.

  2. There is perfect competition both in the commodity and factor market.

  3. Cost of production is expressed in terms of labor i.e. value of a commodity is measured in terms of labor hours/days required to produce it. Commodities are also exchanged on the basis of the labor content of each good.

  4. Labor is the only factor of production other than natural resources.

  5. Labor is homogeneous i.e. identical inefficiency, in a particular country.

  6. Labor is perfectly mobile within a country but perfectly immobile between countries.

  7. There is free trade i.e. the movement of goods between countries is not hindered by any restrictions.

  8. Production is subject to constant returns to scale.

  9. There is no technological change.

  10. Trade between two countries takes place on the barter system.

  11. Full employment exists in both countries.

  12. Perfect occupational mobility of factors of production - resources used in one industry can be switched into another without any loss of efficiency

  13. Perfect occupational mobility of factors of production - resources used in one industry can be switched into another without any loss of efficiency

  14. Constant returns to scale (i.e. doubling the inputs in each country  leads to a doubling of total output)

  15. No externalities arising from production and/or consumption

  16. Transportation costs are ignored

  17. If businesses exploit increasing returns to scale (i.e. economies of scale) when they specialize, the potential gains from trade are much greater. The idea that specialization should lead to increasing returns is associated with economists such as Paul Romer and Paul Ormerod.

Ricardo's Example:-

On the basis of the above assumptions, Ricardo explained his comparative cost difference theory, by taking an example of England and Portugal as two countries & Wine and Cloth as two commodities. As pointed out in the assumptions, the cost is measured in terms of labor hours. The principle of comparative advantage is expressed in labor hours by the following table.

Portugal requires fewer hours of labor for both wine and cloth. One unit of wine in Portugal is produced with the help of 80 labor hours as above 120 labor hours required in England. In the case of cloth too, Portugal requires fewer labor hours than England. From this, it could be argued that there is no need for trade as Portugal produces both commodities at a lower cost. Ricardo however tried to prove that Portugal stands to gain by specializing in the commodity in which it has a greater comparative advantage. The comparative cost advantage of Portugal can be expressed in terms of the cost ratio.

Effects on the economy

Conditions that maximize comparative advantage do not automatically resolve trade deficits. In fact, many real-world examples where comparative advantage is attainable may require a trade deficit. For example, the number of goods produced can be maximized, yet it may involve a net transfer of wealth from one country to the other, often because economic agents have widely different rates of saving.As the markets change over time, the ratio of goods produced by one country versus another variously changes while maintaining the benefits of comparative advantage. This can cause national currencies to accumulate into bank deposits in foreign countries where a separate currency is used.

Considerations

1. Development economics

The theory of comparative advantage, and the corollary that nations should specialize, is criticized on pragmatic grounds within the import substitution industrialization theory of development economics, on empirical grounds by the Singer–Prebisch thesis which states that terms of trade between primary producers and manufactured goods deteriorate over time, and on theoretical grounds of infant industry and Keynesian economics. In older economic terms, comparative advantage has been opposed by mercantilism and economic nationalism.

2. Free mobility of capital in a globalize world

Ricardo explicitly bases his argument on an assumed immobility of capital:" ... if capital freely flowed towards those countries where it could be most profitably employed, there could be no difference in the rate of profit, and no other difference in the real or labor price of commodities, than the additional quantity of labor required to convey them to the various markets where they were to be sold."

Criticism

1. Applicability

Economist Ha-Joon Chang criticized the comparative advantage principle, contending that it may have helped developed countries maintain relatively advanced technology and industry compared to developing countries. In his book Kicking Away the Ladder, Chang argued that all major developed countries, including the United States and United Kingdom, used interventionist, protectionist economic policies in order to get rich and then tried to forbid other countries from doing the same.

2. Assumption rather than discovery

Philosopher and Professor of Evolutionary Psychology Bruce Charlton has argued that comparative advantage is a metaphysical assumption, rather than a discovery. In addition to falsifiable nature of the principle, he notes that the principle relies on several assumptions that are not necessarily operative.

3. Comparative advantage and international trade

Comparative advantage exists when a country has a margin of superiority in the production of a good or service i.e. where the opportunity cost of production is lower.

Ricardo's theory of comparative advantage was further developed by Heckscher, Ohlin and Samuelson who argued that countries have different factor endowments of labor, land and capital inputs. Countries will specialize in and export those products which use intensively the factors of production which they are most endowed.  Worked example of comparative advantage Consider the data in the following table:


Pre-Specialization


CD PlayersPersonal Computers

UK


2,000500

Japan


4,000

2,000


Total Output6,000

2,500


To identify which country should specialize in a particular product we need to analyses the internal opportunity cost for each country. For example, were the UK to shift more resources into higher output of personal computers, the opportunity cost of each extra PC is four CD players. For Japan the same decision has an opportunity cost of two CD players. Therefore, Japan has a comparative advantage in PCs.

Determinants of comparative advantage

Comparative advantage is a dynamic concept. It can and does change over time. Some businesses find they have enjoyed a comparative advantage in one product for several years only to face increasing competition as rival producers from other countries enter their markets.

For a country, the following factors are important in determining the relative costs of production:

  • The quantity and quality of factors of production available: If an economy can improve the quality of its labor force and increase the stock of capital available it can expand the productive potential in industries in which it has an advantage.

  • Investment in research & development (important in industries where patents give some firms significant market advantage .An appreciation of the exchange rate can cause exports from a country to increase in price. This makes them less competitive in international markets.

  • Long-term rates of inflation compared to other countries. For example if average inflation in Country X is 4% whilst in Country B it is 8% over a number of years, the goods and services produced by Country X will become relatively more expensive over time. This worsens their competitiveness and causes a switch in comparative advantage.

  • Import controls such as tariffs and quotas that can be used to create an artificial comparative advantage for a country's domestic producers- although most countries agree to abide by international trade agreements.

  • Non-price competitiveness of producers (e.g. product design, reliability, quality of after-sales support)

  • Interpreting the Theory of Comparative Advantage

A better way to state the results is as follows. The Ricardian model shows that if we want to maximize total output in the world then,

  • First, fully employ all resources worldwide;

  • Second, allocate those resources within countries to each country's comparative advantage industries; and

  • Third, allow the countries to trade freely thereafter.

Importance:

The good in which a comparative advantage is held is the good that the country produces most efficiently. Therefore, if given a choice between producing two goods (or services), a country will make the most efficient use of its resources by producing the good with the lowest opportunity cost, the good for which it holds the comparative advantage. The country can trade with other countries to get the goods it did not produce.

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The Heckscher-Ohlin Trade Model

The Heckscher-Ohlin (HO hereafter) model was first conceived by two Swedish economists, Eli

Heckscher (1919) and Bertil Ohlin. Rudimentary concepts were further developed and added later by Paul Samuelson and Ronald Jones among others. There are four major components of the HO model:

  1. Factor Price Equalization Theorem,

  2. Stolper-Samuelson Theorem,

  3. Rybczynski Theorem, and Heckscher-Ohlin Trade Theorem.

Definition:

Heckscher–Ohlin theorem is one of the four critical theorems of the HeckscherOhlin model. It states that a country will export goods that use its abundant factors intensively, and import goods that use its scarce factors intensively. In the two-factor case, it states: "A capital-abundant country will export the capital-intensive good, while the labor-abundant country will export the labor-intensive good."

The critical assumption of the Heckscher–Ohlin model is that the two countries are identical, except for the difference in resource endowments.

Initially, when the countries are not trading:

  • The price of capital-intensive good in capital-abundant country will be bid down relative to the price of the good in the other country,

  • The price of labor-intensive good in labor-abundant country will be bid down relative to the price of the good in the other country.

Features of the model  

The Heckscher–Ohlin model (H–O 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).

Theoretical development of the model

The Ricardian model of comparative advantage has trade ultimately motivated by differences in labor productivity using different technologies. Heckscher and Ohlin didn't require production technology to vary between countries, so (in the interests of simplicity) the H-O model has identical production technology everywhere. Ricardo considered a single factor of production (labor) and would not have been able to produce comparative advantage without technological differences between countries. The H-O model removed technology variations but introduced variable capital endowments, recreating endogenously the inter-country variation of labor productivity that Ricardo had imposed exogenously.

Extensions

The model has been extended since the 1930s by many economist. Notable contributions came from

Paul Samuelson, Ronald Jones, and Jaroslav Vanek, so that variations of the model are sometimes called the Heckscher-Ohlin-Samuelson model or the Heckscher-Ohlin-Vanek model in the neo-classical economics.

Assumptions of the theory

Heckscher-Ohlin's theory explains the modern approach to international trade on the basis of following assumptions:-

  1. There are two countries involved.
  2. Each country has two factors (labor and capital).
  3. Each country produce two commodities or goods (labor intensive and capital intensive).
  4. There is perfect competition in both commodity and factor markets.
  5. All production functions are homogeneous of the first degree i.e. production function is subject to constant returns to scale.
  6. Factors are freely mobile within a country but immobile between countries.
  7. Two countries differ in factor supply.
  8. Each commodity differs in factor intensity.
  9. The production function remains the same in different countries for the same commodity. For

e.g. If commodity A requires more capital in one country then same is the case in other country.

  1. There is full employment of resources in both countries and demand are identical in both countries.
  2. Trade is free i.e. there are no trade restrictions in the form of tariffs or non-tariff barriers.

The 2×2×2 model

The original H-O model assumed that the only difference between countries was the relative abundance of labor and capital. The original Heckscher–Ohlin 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 "2×2×2 model".

The model has variable factor proportions between countries: Highly developed countries have a comparatively high ratio of capital to labor in relation to developing countries. This makes the developed country capital-abundant relative to the developing nation, and the developing nation labor abundant in relation to the developed country.

The original, 2x2x2 model was derived with restrictive assumptions. 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 labor in either country. 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. 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 must have constant Return to Scale

Both of the countries in the simple HO model produced both commodities, and both technologies have constant returns to scale (CRS). (CRS production has twice the output if both capital and labor inputs are doubled, so the two production functions must be 'homogeneous of degree 1').

These conditions are required to produce a mathematical equilibrium. With increasing returns to scale it would likely be more efficient for countries to specialize, but specialization is not possible with the Heckscher-Ohlin assumptions.

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 F(ish) and A(able) output 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 labor-abundant country can be employed relatively more efficiently in arable farming.

Labor mobility within countries

Within countries, capital and labor can be reinvested and re-employed to produce different outputs. Like the comparative advantage argument of Ricardo, this is assumed to happen costless.

Capital immobility between countries

The basic Heckscher–Ohlin 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.

Differences in labor abundance would not produce a difference in relative factor abundance (in relation to mobile capital) because the labor/capital ratio would be identical everywhere.

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:

Labor immobility between countries

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.This condition is more defensible as a description of the modern world than the assumption that capital is confined to a single country.

Commodities have the same price everywhere

The 2x2x2 model originally placed no barriers to trade, had no tariffs, and no exchange controls. 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 way (Purchasing Power Parity applies).

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.

Econometric testing of H–O model theorems

Heckscher and Ohlin considered the Factor-Price Equalization theorem an econometric success. Modern econometric estimates have shown the model to perform poorly, however, and adjustments have been suggested, most importantly the assumption that technology is not the same everywhere.

Criticism against the Heckscher–Ohlin model

Although H-O model is normally thought to be basic for international trade theory, there are many points of criticism against the model.

Poor predictive power

The original Heckscher–Ohlin model and extended model such as the Vanek model performs poorly, as it is shown in the section "Econometric testing of H-O model theorem. Even when the HOV formula fits well, it does not mean that Heckscher–Ohlin theory is valid. Indeed, Heckscher–Ohlin theory claims that the state of factor endowments of each country determines the production of each country.

Factor equalization theorem

The factor equalization theorem (FET) applies only for most advanced countries. Heckscher–Ohlin theory is badly adapted to the analyze South-North trade problems. The assumptions of HO are unrealistic with respect to North-South trade. Income differences between North and South is the concern that third world cares most. The factor price equalization theorem has not shown a sign of realization, even for a long time lag of a half century.

Identical production function

The standard Heckscher–Ohlin model assumes that the production functions are identical for all countries concerned. This means that all countries are in the same level of production and have the same technology which is highly unrealistic. The standard Heckscher–Ohlin model ignores all these vital factors when one wants to consider development of less developed countries in the international context.[10] Even between developed countries, technology differs from industry to industry and firm to firm base.

Capital as endowment

In the modern production system, machines and apparatuses play an important role. What is named capital is nothing other than these machines and apparatuses, together with materials and intermediate products. Capital is the most important of factors, or one should say as important as labor. By the help of machines and apparatuses’ quantity is not changed at once. But the capital is not an endowment given by the nature. It is composed of goods manufactured in the production and often imported from foreign countries. In this sense, capital is internationally mobile. The concept of capital as natural endowment distorts the real role of capital.

Homogeneous capital

Capital goods take different forms. It may take the form of a machine tool such as a lathe, the form of a transfer machine, which you can see under the belt conveyors.  Despite these facts, capital in the Heckscher–Ohlin Model is assumed as homogeneous and transferable to any form if necessary. This assumption is not only far from the reality, but also it includes logical flaw.

In the Heckscher–Ohlin model, the rate of profit is determined according to how abundant capital is. Before the profit rate is determined, the amount of capital is not measured. This logical difficulty was the subject of academic controversy which took place many years ago. In fact, this is sometimes named Cambridge Capital Controversies. Heckscher–Ohlin theorists ignore all these stories without providing any explanation how capital is measured theoretically.

No unemployment

Unemployment is the vital question in any trade conflict. Heckscher–Ohlin theory excludes unemployment by the very formulation of the model, in which all factors (including labor) are employed in the production.

No room for firms

Standard Heckscher–Ohlin theory assumes the same production function for all countries. This implies that all firms are identical. The theoretical consequence is that there is no room for firms in the HO model.

Unrealistic Assumptions

Besides the usual assumptions of two countries, two commodities, no transport cost, etc. Ohlin's theory also assumes no qualitative difference in factors of production, identical production function, constant return to scale, etc. All these assumptions makes the theory unrealistic one.

Restrictive

Ohlin's theory is not free from constrains. His theory includes only two commodities, two countries and two factors. Thus it is a restrictive one.

One-Sided Theory

According to Ohlin's theory, supply plays a significant role than demand in determining factor prices. But if demand forces are more significant, a capital-abundant country will export labor-intensive good as the price of capital will be high due to high demand for capital.

Static in Nature

Like Ricardian Theory the H-O Model is also static in nature. The theory is based on a given state of economy and with a given production function and does not accept any change.

Wijnholds's Criticism

According to Wijnholds, it is not the factor prices that determine the costs and commodity prices but it is commodity prices that determine the factor prices.

Consumers' Demand ignored

Ohlin forgot an important fact that commodity prices are also influenced by the consumers' demand.

Haberler's Criticism

According to Haberler, Ohlin's theory is based on partial equilibrium. It fails to give a complete, comprehensive and general equilibrium analysis.

Leontief Paradox

American economist Dr. Wassily Leontief tested H-O theory under U.S.A conditions. He found out that U.S.A exports labor intensive goods and imports capital intensive goods, but U.S.A being a capital abundant country must export capital intensive goods and import labor intensive goods than to produce them at home. This situation is called Leontief Paradox which negates H-O Theory.

Other Factors Neglected

Factor endowment is not the sole factor influencing commodity price and international trade. The H-O Theory neglects other factors like technology, technique of production, natural factors, different qualities of labor, etc., which can also influence the international trade.

Importance

The critical assumption of the Heckscher–Ohlin model is that the two countries are identical, except for the difference in resource endowments. This also implies that the aggregate preferences are the same. The relative abundance in capital will cause the capital-abundant country to produce the capitalintensive good cheaper than the labor-abundant country and vice versa.

(Source: Slideshare. International Business Theories. Retrieved from: http://www.slideshare.net/ronobirOne/international-business-theories-of-international-trade)

Summary of International Trade Theories


[slideshare id=759969&doc=international-trade-theories-1226929140596587-8]

 

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