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Testing the Heckscher Ohlin Theorem-

CHINA – GERMANY
Academic Group – 6

 Dhruvin Deora (A013)


 Riya Agarwal (A039)
 Priyanka Shanbhag (A038)
 Mihir Merani (A029)
 Dhruv Panchal (A012)
 Harshika Pasari (A017)
 Vedansh Agarwal (A054)

Abstract
The Heckscher Ohlin theorem is one of the most important trade theories in international
trade. In this report, we have analysed this theory with the perspective of Germany and
China. Our rationale behind selecting these countries was to see how a country with abundant
cheap labour that made it the largest output manufacturing country trades with a country that
is in forefront in terms of technology and innovation. We have taken the timeline from 2012-
2014 so we have a stable but long enough time period to evaluate H-O theorem and relatively
new as H-O theorem is a flow concept because countries might develop and shift from labour
to capital over a period of time and vice-versa.

 
Introduction
The Heckscher-Ohlin theorem states that if two nations produce two goods and use two
factors of production (i.e. labour and capital) to produce these goods, each nation will export
the good which requires intensive use of its abundant factor of production. This makes
production of goods relatively cheap and both nations can benefit from trade.
  
In our case, China is a relatively labour abundant economy and Gerrmany is a relatively
capital abundant one.  If we compare the very obvious choice of goods that both nations
would export, it would be cheap manufactured goods from China whereas it will import
capital intensive goods from Germany. Thus, at first glance we can predict from the H-O
theorem is this pattern of trade, in absence of relaxations to assumptions.

In real life many of these assumptions don't hold true. Hence we examine the real life trade
scenario between these two nations.

LITERATURE REVIEW

The paper by University of Nigeria (KALU David-Wayas) empirically tests if Nigeria’s


pattern of production and trade with USA are consistent with the Heckscher-Ohlin
framework. The secondary sources of data to support this were collected from the Central
Bank of Nigeria and United Nation Conference on Trade and Development
(UNCTAD).Nigeria, naturally endowed with abundant labour ,rich soils and favourable
climatic conditions survived on its labour intensive agricultural production(which constituted
more than 95% of its total export share) till the late 1950’s.However when oil was discovered
it replaced cocoa, groundnut , palm products (major agricultural labour intensive exports) as
the largest foreign exchange earner(it constituted 91.5% of total export share in 2008) even
though it is not a capital geared country. Nigeria which is relatively labour intensive thus
produced relatively capital-intensive product (crude oil) for exports to USA (even though it is
labour abundant) and also imported capital intensive goods from USA (passenger vehicles,
oil field and drilling equipment required for oil production) which is inconsistent with the H-
O theorem. This is because Nigerian experience has proven H-O theory as a dynamic model
against static model argued by others. Also, since both the nations are geared towards capital
intensive goods, factor price equalisation does not take place. An implication of this
framework is that trade increases the real return to the factor that is relatively abundant in
each country. So, it was expected that in developing countries like Nigeria that were well-
endowed with unskilled labour, wages of unskilled workers would increase relative to skilled
workers reducing income inequalities but it did not. Because USA is capital abundantly
endowed and Nigeria is capital scarcely endowed, it results to trade imbalance between the
two and US gains while Nigeria loses. Therefore, the government should use these findings to
steer the economy towards a more labour-intensive approach through incentivising foreign
investors to invest in agricultural industry and imposing tariffs or quotas on imported
agricultural commodities which could be produced locally.

Further work like that by Michael Hodd (US &UK-Published by Wiley on behalf of
The London School of Economics and Political Science) presents a test of the
Heckscher-Ohlin (H-O) theory of trade flows along the lines developed by Leontief. The H-O
theory boldly asserts that factor endowments determine trade flows. The results obtained after
this test, however, appear to be inconsistent with the H-O theory.This article considers only
those goods which are produced in both countries and the goods which do not require any
specific factor other than capital and labour.The article has studied trade between US and UK
in 1947, because it reduces the chance of taste differences and factor reversal.It calculates the
capital to labour endowment ratios of the UK, the US, and the ROW, and it turns out that the
US is capital-abundant relative to the UK, and that the UK is capital-abundant relative to the
ROW.47 sectors were taken into consideration.The method used is calculating capital inputs
in a nation , taking inverse of the input-output table and calculating the time period.
Multiplying these matrices, we get the total amount of capital required to produce these
goods. The average wage was calculated by dividing the total salaries of employees by the
labour force in the countries.The results show that in her trade with the rest of the world, the
UK seems to use more of both factors in producing $1mn. of exports than if it were to
produce itself the imports for which they are traded, since UK's imports have higher content
of natural resources. Also, the capital-labour ratios of US imports are all much higher than
the capital-labour endowment ratio of the US.( This was also shown for US trade with the
rest of the world by Leontief).

This report is a contribution to the larger findings and empirical evidences on the Hecksher-
Ohlin theorem. The first anomaly to the theorem was found by Leontief (Leontief, 1953) that
subsequently came to be known as the ‘Leontief’s Paradox’. It revealed that USA despite
being capital abundant, is exporting goods that are comparatively more labor intensive.
Further findings (University of Groningen 2008) tell us that the Leontief’s Paradox holds true
for Sino-Indian as mentioned- ‘…the Leontief Paradox finds support in China-India trade’.
The authors site raw material abundance in India as the reason for the paradox. Indian exports
are largely composed of goods that are simple conversion from the raw materials but are
considered as capital intensive exports. When agriculture sector is not accounted for, the
research finds that the Hecksher-Ohlin theorem holds. China’s trade with 11 regions was
studied in the above mentioned paper, and it was found that the H-O theorem holds true. The
regions were chosen on the basis of share in China’s total trade volume. Studying the nature
of China’s foreign trade with the world, it can be said “China resorts to foreign trade in order
to economize its capital and dispose of its surplus labor”. Thus, the H-O theorem hold true.
However, this report attempts to analyze whether the same holds true in case of trade between
China and Germany.

Methodology:
In the time frame that we chose to evaluate the H-O theorem, it was very evident that
Germany is clearly Capital (K) abundant while China is Labour (L) abundant as the exports
made by Germany to the Rest of the World are clearly capital intensive, i.e., they require a
higher level of technical background, knowledge and capital than labour. The term ‘unskilled
labour’ is to be introduced here as the labour being referred to, in the above scenario is not
knowledgeable; that part of labour is taken in Human Capital and added to the Capital side of
the factor endowments. We cannot take wage rates as a basis for our evaluation of skill as the
population difference in these nations have a great effect on demand and supply of labour in
labour markets which in turn affects the wage rates and also the policy actions of both the
countries differ to a vast extent which might be another factor acting as incentives and
disincentive for people to gain knowledge and add to human capital.

The factor abundance of both nations is confirmed by using the formula Gross Fixed Capital
Formation divided by the labour of both the nations. This formula has majorly been
influenced by the research conducted by Pei, J. and Osterhaven, J. and consolidated in the
paper ‘The Nature of China’s Foreign Trade: Heckscher-Ohlin, Trade Theory Re-Examined.
This is used to find TK/TL which tells which country has relative comparative advantage in
which commodity (as commodities are produced using different combinations of both capital
and labour). According to H-O Theorem the countries should be exporting the commodity
that requires more factor that the particular nation is endowed with. From an untrained or
quick oversee of the major exports of both China and Germany may lead us to think that both
Germany and China are exporting Capital Intensive commodities to each other, this might
force us to modify the H-O theorem. However, the flaw with this type of oversee is that it
doesn’t factor into what China and Germany are importing to make such exports possible.

To verify what a brief oversee at the exports and imports tells us we will be using the smiling
curve evaluation wherein we will find out where a country lies on the smiling curve. If the
country lies higher on the smiling curve or the ‘Global Value Chain’ indicates that the
country is exporting its Capital which is translated into the commodity, but if the country lies
lower on the Smiling Curve then this is an indication of labour being exported (translated into
a commodity). While the commodity maybe capital intensive but any respective country
(China) maybe using the labour to just assemble the product and export it to the neighbouring
markets.
We are therefore using a different understanding of H-O theorem wherein we are not looking
at the fact that country is exporting which type of product but rather country is exporting
what factor endowment that is translated into that product. From the above mentioned
research paper, since we are using Human Capital Factor as a part of (K), thus we can say
that any country on the production phase is adding the least value to the products and thus it
is using more of its labour to carry out the processes like ‘Assembling’ and ‘Line Production’
where skilled labour is not required lies closer to the production phase of the smiling curve.

To calculate where a country lies on the Value Added Chain we came up with the formula:

αe
μ=
β−αi

µ: Location on value added chain (lower it is, nearer the country is to Production Phase)

αe: Value of export of component(s) required to make the final commodity(ies).

β: Value of exports of Final goods taken

αi: Value of import of component(s) required to make the final commodity(ies).

Analysis
To determine the factor abundance of both the nations we derive the formula of gross
domestic fixed capital formation (gfcf) divided by the labour of both the nations (This
method was influenced by the reference given in the paper “The Nature Of China’s Foreign
Trade: Re-examined by Pei,J.; Oosterhaven,J”
The figures over here are given in
Capital per labour in US$.

In the above figures, China clearly is abundant in both the factor endowments and has an
absolute advantage in both of them but the K/L ratio tells us that China has a comparative
advantage in labour.

As seen from the above scatter plot diagrams there is a complete straight trend in both China
and Germany where both of them are increasing over the given time period. Now according
to the H-O theorem China should be exporting labour intensive commodities while Germany
exports capital intensive commodities. To put this assumption into context we find the
following top 4 commodities exported by nations to each other and our finding are as
follows:
China exports to Germany

The tables above are contradicting H-O theorem as China is exporting capital intensive
commodities like Metals and Computers whose extraction and production costs very high.
This is an anomaly and we now move to the Smiling Curve Analysis of 2 commodities from
the above table from China to Rest of the World and Germany to Rest of the World for
Computers and Textiles and Cars and Plastic and Rubbers respectively.

Putting the value in formula above:


144.61
μ ( cars )= =1.32173
160−50.59

24.51
μ ( plastic∧rubber )= =4.64205
22.96−17.68

80.3
μ( computers)= =1.18472
113−45.22

15.18
μ ( textiles ) = =0.14164
107.95−0.78

From µ we conclude that China is exporting labour intensive goods while Germany
exports capital intensive goods.

Limitations:

The various inherent assumptions of the Heckscher Ohlin Theorem make it unrealistic to test
its practical applicability in the real-life scenario. There are technological changes and
differences that haven’t been taken into account.

Due to strategical placement of companies they have locational advantage which means that
they can use more of either capital or labour to produce the same particular product, this can
skew the import/export of parts since parts are not in absolute terms but in monetary terms,
hence it depends on the acquisition costs of companies for parts of final commodities which
might vary.

Another large shortfall of is the size of the sectors taken under analysis, for example –
Textiles sector of China and the plastic and rubber industry of Germany, are very vast
industries which include everything from undergarments to jackets to overalls and Plastic lids
to Rubber tyres. This creates a disparity from intra sectoral product-by-product analysis.

Product differentiation and quality of the same product varies from country to country this
might lead to a countries (companies) importing higher quality component and exporting am
inferior quality component.

Price control by different countries and companies may lead to an artificial price rise of all
the goods and this may vary from country to country.

Some countries might add value to the component that they import and might also use these
components in many other commodities, e.g. microchips in both computer and mobile
phones, which can hinder with the analysis as almost all companies are diversified and they
produce products that are similar to each other.

CONCLUSION:

To conclude our research, we have reached these final deductions:

1. Germany is relatively capital abundant clearly exporting its capital factor translated
into goods.
2. China is relatively labour abundant exporting its labour factor translated into final
goods
3. This conclusion extends beyond H-O theorem as commodities maybe both capital or
labour intensive but we need to find what a country contributes in its production
process which make the goods it exports capital or labour intensive accordingly.
(China is importing components of the product and engages only in the assembly of
the final good using its abundant labour which makes its final good look capital
intensive even though its labour intensive)
4. Thus H-O theorem holds true in our study if we consider the factor intensity by
looking at real value additions.

Bibliography

Sources of Literature review

https://www.jstor.org/stable/2552510?seq=1#metadata_info_tab_contents
https://pdfs.semanticscholar.org/21f7/17080c6547d55b3de4d7b8a9287fdaa1e27c.pdf
 
https://www.google.com/url?sa=t&source=web&rct=j&url=https://www.iioa.org/conferences/intermediate-
2008/pdf/3b1_Pei.pdf&ved=2ahUKEwj4zP2wvtfnAhUhxzgGHYtrDmIQFjAMegQIARAB&usg=AOvVaw1

Sources of Import export data


 
https://oec.world/en/visualize/tree_map/hs92/export/deu/chn/show/2014/

https://oec.world/en/visualize/tree_map/hs92/export/deu/chn/show/2013/

https://oec.world/en/visualize/tree_map/hs92/export/deu/chn/show/2012/

https://oec.world/en/visualize/tree_map/sitc/import/deu/chn/show/2012/

https://oec.world/en/visualize/tree_map/sitc/import/deu/chn/show/2013/

https://oec.world/en/visualize/tree_map/sitc/import/deu/chn/show/2014/

https://oec.world/en/visualize/tree_map/hs92/export/deu/all/show/2014/

https://oec.world/en/visualize/tree_map/hs92/import/deu/all/show/2014/

https://oec.world/en/visualize/tree_map/hs92/export/chn/all/show/2014/

https://oec.world/en/visualize/tree_map/hs92/import/chn/all/show/2014/

https://data.worldbank.org/indicator/SL.TLF.TOTL.IN?
end=2014&locations=KR&most_recent_value_desc=true&start=2011  
 
https://data.worldbank.org/indicator/NE.GDI.FTOT.CD?

References

Pei, J. and Osterhaven, J. and consolidated in the paper ‘The Nature of China’s Foreign
Trade: Heckscher-Ohlin, Trade Theory Re-Examined

UGBOR, I. KALU David-Wayas, Onyinye. M.Nwanosike, Dominic U.


University of Nigeria, Nsukka Enugu, Nigeria

US &UK-Published by Wiley on behalf of The London School of Economics


and Political Science by Michael Hodd

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