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Updated on July 4, 2011

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 that is widely is still widely accepted today. Whereas Smith and Ricardo emphasized a labor theory of value the factor proportions theory was based on a more modern concept of production that raised capital to the same level of importance as labor.

Factor Intensity in Production

The factor intensity in production theory considered two factor of production, labor and capital. Technology determines the way they combine to form a product. Different products required different proportions of the two factors of production.

It is easy to see how the factor proportions of how a product is produced differs substantially among groups of products. For 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, however although requiring some highly skilled labor require massive quantities of capital for production and development and the manufacturing facilities needed for clean production to ensure the extremely high quality demanded in the industry. 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 a product. The theory assumed 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 at 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 requires 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. And 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 the 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 with other countries more labor and less capital it would be characterized as relatively labor abundant. That which is more plentiful is cheaper; so a labor abundant country would therefore have relatively cheap labor.

For a country such as China possesses a relatively large endowment of labor and a relatively smaller endowment of capital. At the same time Japan is a relatively capital abundant country with a relatively smaller endowment of labor. China possesses relatively 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. Comparative advantage is derived not from the productivity of a country, but from the relative abundance of its factors of production.

Using these assumptions, factor proportions theory stated that a country should specialize in the production and export of those product that use intensively its relatively abundant factor.

(i) 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.

(ii) 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.

Global Learning Experience indicates the strong feeling of developing nations toward improving labor standers which they think would deprive them of their comparative advantage cheap labor.

The Leontief Paradox

One of the most famous tests of any economic or business theory occurred in 1960, when economist Wisely Leontief tasted 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 shard view that some countries such as the United States 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 b more efficient in producing labor intensive products.

Leontief first 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 relatively 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 relatively more labor intensive than the products the United States imported8. It seemed that if the factor proportions theory was true the United States is 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. First it was thought to have been simply a result of the specific year (1946) that the data were for. However the same result were found with different years and data sets. Second it was noted that Leontief did not really analyze the labor and capital contents of imports, but rather the labor and capital contest was actually producing these products in a more capital intensive fashion than were the countries from which it also imported these manufactured goods9. Finally the debate turned to the need to distinguish different types of labor and capital. For 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 predict for country trade patterns. Finally 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 result 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 the demand side, rather than the production or supply side.

Linder argued that trade in manufactured goods was dictated not by cost but rather by the demand for similar type products across countries. His theory was based on two principles:

1. 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.

2. 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 product demands. For the United States and Canada have similar per capita income levels and in both countries consumers demand similar products both in complexity and quality.

By comparison the United States and Mexico have significantly different per capital income levels and as might be anticipated have dissimilar consumer product demands. The conclusions drawn from Linder's theory differed from the cost-oriented theories that preceded it. First the most intensive trade would exist between countries of the same income or industrialization levels. Second the theory implied a large part of global trade would be what be what is commonly referred to as intraindustry trade, which is the exchange of essentially identical goods between countries; for the United State exporting automobiles to Europe and, at the same time, Europe exporting automobiles to the United States. Global Learning provides an indication of the impact of low-cost imports on the U.S. steel industry.


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    • chefsref profile image

      Lee Raynor 5 years ago from Citra Florida

      Hey Saif

      Is factor theory something used by businesses for planning, or is it just a way to explain what has already happened?

      I think the perhaps unintended outcome of global trade is that we (in the USA) are seeing our standard of living decline while China, India, et al are raising theirs at our expense. Are we in a zero sum game?

    • lionel1 profile image

      lionel1 5 years ago

      Thank you for you in depth post on 'Factor Proportions Theory' it's all new to me, but I found it very interesting.

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