Factor endowment theory(Heckscher Ohlin theory) explains the cause of comparative cost difference as the basis of international trade. The theory is usually expounded in terms of a two factor model with labor and capital as the two factor of endowment.
The theory suggests that the trade is determined by differences in factor endowments i.e. the countries rich in labor will export labor intensive goods and the only rich in capital will export capital-intensive goods.
TWO FACTOR MODEL
- There are two countries A and B
- There are two factors labor and capital
- There are two goods : X and Y
– X labor intensive
– Y capital-intensive
- Country A : Labor abundant and Country B : Capital abundant
- Perfect competition in both the commodity and factors
- All production functions are homogeneous
P stands for the factor price
K stands for capital; L stands for labor
A and B respective countries
- XX and YY are two isoquants for products X and Y respectively i.e. price at same quantity XX and YY intersects only once and thus X will always be capital-intensive relating to Y
- Relative factor prices in country A are depicted by slope of line P
- Slope of line representing relative factors prices must be less than that of PA.
- Line PˡB is tangent to isoquant YY at T. The line RS is drawn parallel to PˡB tangential to XX.
- In country A equilibrium factor proportion are as follows:- OZ for good X- OQ for good Y
- This means that cost of producing given quantity of X in country A is the cost of using the two factors K and L at relative factor prices given by PA.
- The cost of producing given amount of X in country A is the cost of using capital in amount of OP
- The cost of producing given amount of Y in country A is equal to OP (cost of using capital in quantity OP)
- In the same manner for country B. The cost of production for given amount of X is more than that for given amount of Y. Hence producing X is more expensive than producing Y.
- Comparing the relative cost of the equal amount of X and Y in countries A and Y is cheaper in B.
- Therefore, capital abundant country has a comparative cost advantage in producing capital-intensive goods.