Factor Proportions Theory Explained
Factor Proportions Theory
Trade theory, like all of economic theory, changed drastically in the first half of the twentieth century. The factor proportions theory developed by the Swedish economist Eli Heckscher, and later expanded by his former graduate student Bertil Ohlin, formed the major theory of international trade and is still widely accepted today. Whereas Smith and Ricardo emphasized a labor theory of value, the factor proportions theory is based on a more modern concept of production that raises capital to the same level of importance as labor.
Factor Intensity in Production
The factor intensity in production theory is a two-dimensional concept and includes labor and capital. Technology determines the way labor and capital combine to form a product. Different products require different proportions of these two factors of production.
It is easy to see how the factor proportions of the production of a product differs substantially among groups of products. For example, the manufacturing of leather footwear is still a relatively labor-intensive process, even with the most sophisticated leather treatment and patterning machinery. Other products, such as computer memory chips, still require some highly skilled labor, but rely more on massive quantities of capital for production, development, and facilities. The concept of factor proportions is very useful in the comparison of the production processes of goods.
According to factor proportions theory, factor intensities depend on the state of technology and the current method of manufacturing of a given product. The theory assumes that the same technology of production would be used for the same goods in all countries. It is not, therefore, differences in the efficiency of production that will determine trade between countries, as it did in classical theory. Classical theory implicitly assumed that technology, or the productivity of labor, is different across countries. Otherwise, there would be no logical explanation as to why one country would require more units of labor to produce a unit of output than another country. Factor proportions theory assumed no such productivity differences.
Factor Endowments, Factor Prices, and Comparative Advantage
If there is no difference in technology or productivity of factors across countries, what, then, determines comparative advantage in production and export? The answer is that factor prices determine cost differences. These prices are determined by the endowments of labor and capital the country possesses. The theory assumes that labor and capital are immobile, meaning they cannot move across country borders. Therefore, a country's endowment determines the relative costs of labor and capital as compared to other countries.
Each country is defined or measured by the amount of labor and capital that it possesses. If a country has, when compared to other countries, more labor and less capital, it would be characterized as relatively labor abundant. That which is more plentiful is cheaper. Thus, a labor-abundant country would have relatively cheap labor.
A country such as China possesses a relatively large endowment of labor and a smaller endowment of capital. Japan is a relatively capital-abundant country with a smaller endowment of labor. China possesses cheaper labor and should therefore specialize in the production and export of labor-intensive products. Japan possesses relatively cheap capital and should specialize in the production and export of capital-intensive products. The comparative advantage is derived not from the productivity of a country, but from the relative abundance of its factors of production.
Operating with these assumptions, the factor proportions theory states that a country should specialize in the production and export of those products that make use of its relatively abundant factor.
- A country that is relatively labor abundant should specialize in the production of relatively labor intensive goods. It should then export these labor intensive goods in exchange for capital intensive goods.
- A country that is relatively capital abundant should specialized in the production of relatively capital intensive goods. It should then export these capital intensive goods in exchange for labor intensive goods.
The Leontief Paradox
One of the most famous tests of any economic or business theory occurred in 1960, when economist Wisely Leontief tested whether the factor proportions theory could be used to explain the types of goods the United States imported and exported.
Leontief's premise was based on a widely shared view that some countries, such as the U.S., were endowed with large amounts of capital equipment, while other countries were short on capital but well-endowed with large amounts of labor. Thus, it was thought that a country with significant capital would be more efficient in producing capital-intensive products, and that a country with large amounts of labor would be more efficient in producing labor-intensive products.
Leontief had to devise a method to determine the relative amounts of labor and capital in a product. His solution, known as input-output analysis, was an accomplishment on its own. Input-output analysis is a technique of breaking down products into the amounts and costs of the labor, capital, and other potential factors employed in the product's manufacture. Leontief then used this method to analyze the labor and capital content of all U.S. merchandise imports and exports. The hypothesis was relatively straight forward: U.S. exports should be more capital-intensive than U.S. imports. Leontief's results were, however, a bit of a shock.
Leontief found that the products that U.S. firms exported were more labor-intensive than the products the U.S. imported8. It seemed that if the factor proportions theory were true, the U.S. would be identified as a relatively labor-abundant country. Alternatively, the theory could be wrong. Neither interpretation of the results was acceptable to many in the field of international trade research.
A variety of explanations and continuing studies have attempted to solve what has become known as the Leontief Paradox. It was first thought to have been simply a result of the specific year when the study was conducted, which was 1946. However, the same results were found when the theory was applied to different years and data sets. The next explanation was that Leontief did not really analyze the labor and capital contents of imports, but rather the labor and capital content was actually producing these products in a more capital-intensive fashion than the countries from which it imported manufactured goods. Finally, the debate turned to the need for analysts to distinguish different types of labor and capital. Several studies attempted to separate labor factors into skilled labor and unskilled labor. These studies have continued to show results more consistent with what the factor proportions theory would suggest. In the 1970s, a number of studies expanded the factors of production to include energy, particularly oil, as a factor of production that would explain the paradox. The results to date have been mixed, at best.
Linder's Overlapping Product Ranges Theory
The difficulty in confirming the factor proportions theory led many scholars in the 1960s and 1970s to search for new explanations of why countries trade with each other. The work of Staffan Burenstam Linder focused on the preferences of consumers, or demand, rather than production or supply.
Linder argued that trade in manufactured goods was dictated not by cost, but by the demand for similar types of products across countries. His theory was based on two principles:
- As per capita income rises the complexity and quality level of products demanded by a country's residents also rises. The range of product sophistication demanded by a country's residents is largely determined by its level of income.
- The business firms that produce a society's need are more knowledgeable about their domestic markets than foreign markets. The firms could not be expected to effectively service a foreign market that is significantly different from the domestic market because the ability to compete comes from experience in the home market. A logical pattern would be for the firm to gain success and market share at home first, and then expand to foreign markets that have a demand for similar products.
Global trade in manufactured goods among nations would then be influenced by the demand for similar products. The countries that would engage in the most intensive trade would be those with similar per capita income levels, for they would possess a greater likelihood of overlapping when it comes to product demands. For example, the U.S. and Canada, which have similar per capita income levels, have consumer product demands for similar products when it comes to complexity and quality.
By comparison, the U.S. and Mexico have significantly different per capita income levels and, as such, might be anticipated to have dissimilar consumer product demands. The conclusions drawn from Linder's theory differed from the cost-oriented theories that preceded it: The most intensive trade would exist between countries of the same income or industrialization levels, and a large part of global trade would be referred to as intraindustry trade, which is the exchange of essentially identical goods between countries, such as the U.S. exporting automobiles to Europe and, at the same time, Europe exporting automobiles to the U.S.
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