Comparative advantage theory of international trade took only one factor of production i.e. labour. Heckscher-Ohlin argued that it is caused because different countries have different factor endowments. This theory studies the relationship between commodity and factor prices and relationship between input and output. It takes a general equilibrium approach to the study of international trading relationship between countries.
Country with capital abundance will be able to produce capital intensive products efficiently and the country with labour abundance will be able to produce labour intensive products efficiently. This is because the cost of capital i.e. rate of interest will be low in countries with abundant capital while salaries & wages will be low in countries with abundant labour.
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Hence a product which requires more capital than labour will be cheaper in capital abundant country. Taking the example of USA and India, it can be said that India, which is abundant in manpower but lacks capital resources will be able to produce good-efficiently, which uses relatively more labour. USA, which has abundant capital relative to manpower, will be able to produce good efficiently, which uses relatively more capital.
(i) Assumptions of Heckscher-Ohlin theory:
1. There is perfect competition in commodity as well as factor market.
2. The technology for producing a good is different for different countries but it will be same for a product produced in different countries.
3. Factors of production are mobile within the country but are unable to move from one country to another.
(ii) Limitations of Heckscher-Ohlin Theory:
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1. Labour in India is not of the same quality as in USA, Japan or Europe. Labour is trained in developed countries with at least fifteen years’ duration, while most of the labour in underdeveloped country is illiterate and untrained. Hence labour is not homogeneous.
2. As the capital intensity increases, the quality of labour required to operate it should also be high. Hence it is not possible for a product to be produced by same production technique in two different countries with different level of development.
3. Cost of production is not just a function of cost of factors of production but also of the rate of improvement in technology in different countries. USA is spending lot more on Research & Development than India. Therefore, cost of production decreases at greater rate in USA than India.
4. Factor endowment of a country may change over time.