How Does Demand Reversal Invalidates the Theory of Hecksher-Ohlin Theorem

Only available on StudyMode
  • Download(s): 2105
  • Published: September 19, 2010
Read full document
Text Preview
The modern theory of international trade
Figure 1.1 DEMAND REVERSAL

Country A produces at point A, specializing in the production of steel, it consumes at point D, given the utility pattern represented by the indifference curve (IC a). This means that country A exports EA amount and import ED amount of steel. Therefore country A which is a capital surplus country is exporting labour intensive goods (cloth) and importing capital intensive goods (steel). This is in direct conflict with the HECKSCHER OHLIN prediction concerning the commodity structure of trade. Likewise, country B specializes in the production of cloth, but it consumes at point G in response to its utility pattern represented by the indifference (IC b). Therefore it exports BF amount of steel and imports FG amount of cloth. Once again we notice that country B, which is a labour surplus country exports capital intensive goods (steel) and imports labour intensive goods (cloth). The HECKSCHER OHLIN prediction is overturned. In this case, represented in figure 1.1 we have a situation of what is called demand reversal. Here not only the two biases-consumption and production are in the same direction but also the consumption bias more than offsets the production bias. Consumption point D lies to the left of production point A in country A and in country B the consumption point G lies to the right of production point B. When such a demand reversal takes place, the capital surplus country would export labour intensive goods. The HECKSCHER OHLIN theory would then be invalidated by the demand reversal Critical evaluation of the HECKSCHER OHLIN theorem

In the area of pure theory of international trade, the HECKSCHER OHLIN model occupies a very prestigious position. The very fact that many known Economists like Leontief, Walters, Minhas and others have tried to test the empirical validity of the HECKSCHER OHLIN theorem using econometric models, stands as a testimony of the prestige of the model. The HECKSCHER OHLIN theorem has been criticised mainly along the following lines: the factor intensity reversal, Leontief and paradox and demand reversal argument Factor intensity argument

The HECKSCHER OHLIN theorem was based on the assumption that the production functions are different for different goods but they are identical for each good in two countries. This, in other words means that one good is capital intensive and the other good is labour intensive, but the same good which is capital intensive in one country, must be capital intensive in the other country also and the labour intensive good remains labour intensive in both the countries. This assumption is guaranteed when both the two production isoquants for capital intensive and labour intensive cut each other only once but not more than once in diagram 1 this is shown to happen at point Q. The demonstration in diagram 1 is consistant with the HECKSCHER OHLIN assumption of non-reversability of factor intensities. If factor intensity reversal takes place, then two isoquants will cut each other more than once and the HECKSCHER OHLIN theorem would turn out to be invalid this case is demonstrated in the following diagram.

The two production isoquants for steel and cloth cut each other twice in the succeeding diagram: once at point A and the second time at point B. The factor price ratios in country A(capital surplus country) are represented by the parallel lines P 0 P 0. P 1 P 1 represent the factor price ratios in country B(Labour surplus country). In the above diagram note the following factors: in country A steel is labour intensive. In order to produce one unit of either steel or cloth, country A has to use the same amount of capital but more labour for steel than cloth. Cloth has a higher capital-labour ratio and steel has a lower capital-labour ratio. Therefore, a capital rich country like country A would specialize in the production and export of the capital intensive goods, which is cloth. It would...
tracking img