Factor endowment theory

The principles of absolute and relative advantage provide a primary basis for trade to occur, but the usefulness of these principles is limited by their assumptions. One basic assumption is that the advantage, whether absolute or relative, is deter- mined solely by labor in terms of time and cost. Labor then determines comparative production costs and subsequent product prices for the same commodity.

If labor is indeed the only factor of production or even a major determinant of product content, countries with high labor cost should be in serious trouble. An interesting fact is that Japan and Germany, in spite of their very high labor costs, have remained competitive and have performed well in trade. It thus suggests that absolute labor cost is only

^{Figure 2.2 Absolute advantage without relative}

advantage (identical domestic exchange ratios)

one of several competitive inputs that determine product value. Tables 2.2 and 2.3 show incomes, working hours, and vacation days across major cities.

It is misleading to analyze labor costs without also considering the quality of that labor. A country may have high labor cost on an absolute basis; yet this cost can be relatively low if productivity is high. Countries with low wages tend to have low pro- ductivity. Any subsequent productivity gains usually result in higher wages and currency appreciation.

Furthermore, the price of a product is not necessarily determined by the amount of labor it embodies, regardless of whether or not the effi- ciency of labor is an issue. Since product price is not determined by labor efficiency alone, other factors of production must be taken into considera- tion, including land and capital (i.e., equipment). Together, all of these production factors contribute significantly to the creation of value within a particular product.

One reason for the importance of identifying other factors of production is that different com- modities require different factor inputs and that no country is well endowed in all production factors. The varying proportion of these factors embodied in various goods has a great deal of impact on what a country should produce. Corn, for instance, is best produced where there is an abundance of land (rel- ative to labor and capital), even though corn can be grown in most places in the world. Oil refining, in contrast, requires relatively more capital and

Table 2.2 Wage levels around the globe

City Gross, Net, City Zurich = 100 Zurich = 100				Gross, Zurich = 100	Net, Zurich = 100
Zurich	100.0	100.0	Singapore	26.8	28.3
Copenhagen	98.9	74.8	Dubai	26.4	35.2
Basel	97.7	95.8	Lisbon	23.6	25.1
Oslo	94.9	87.0	Manama	22.8	29.4
Geneva	91.1	88.5	Ljubljana	21.2	17.6
New York	84.7	78.6	Johannesburg	19.1	20.0
Lugano	84.3	85.1	Istanbul	17.9	16.7
Chicago	82.5	81.0	Budapest	16.6	15.6
Los Angeles	72.2	72.9	Kuala Lumpur	14.5	16.3
Frankfurt	70.0	59.9	Warsaw	13.0	11.4
Luxembourg	69.4	75.4	Shanghai	12.8	12.5
Tokyo	68.3	70.5	Santiago de Chile	12.7	14.4
Brussels	67.9	56.0	Riga	12.6	12.2
London	65.6	63.9	Tallinn	12.4	11.9
Amsterdam	64.7	57.0	Prague	11.8	12.4
Stockholm	64.7	56.5	Vilnius	11.2	10.1
Berlin	63.9	54.5	Moscow	11.1	13.4
Dublin	63.5	66.1	Sao Paulo	10.4	11.9
Miami	62.4	63.1	Lima	9.9	11.3
Helsinki	58.2	56.6	Bratislava	9.7	9.8
Vienna	55.8	52.3	Caracas	9.2	11.0
Paris	53.4	52.2	Mexico City	9.2	10.7
Toronto	52.6	48.8	Rio de Janeiro	8.4	9.2
Montreal	50.1	48.0	Bogotá	8.3	10.0
Milan	44.5	40.3	Buenos Aires	7.9	8.7
Sydney	40.2	40.7	Bucarest	7.2	11.9
Barcelona	38.0	41.1	Bangkok	6.9	8.6
Rome	37.1	33.4	Jakarta	6.5	7.8
Madrid	35.3	39.2	Manila	5.4	6.0
Athens	34.6	37.3	Sofia	5.3	5.6
Auckland	34.5	35.3	Kiev	5.0	5.8
Tel Aviv	32.8	33.2	Lagos	5.0	6.5
Taipei	32.3	35.5	Nairobi	4.2	4.8
Hong Kong	31.1	36.4	Karachi	3.5	4.1
Seoul	30.6	30.7	Mumbai	3.1	3.6

Source: Prices and Earnings (Zurich: UBS AG, 2003), 7.

Table 2.3 Working hours and vacation days around the globe

City	Working hours per year	Vacation days per year	City	Working hours per year	Vacation days per year
Hong Kong	2398	8	Zurich	1872	23
Mumbai	2347	25	Basel	1868	23
Taipei	2327	13	Tokyo	1864	16
Karachi	2302	27	Riga	1862	20
Manila	2301	14	Chicago	1858	15
Mexico City	2281	14	Miami	1856	20
Seoul	2270	20	New York	1843	10
Dubai	2233	26	Vilnius	1833	26
Santiago de Chile	2195	15	Ljubljana	1830	22
Bangkok	2184	10	Montreal	1829	19
Jakarta	2175	11	Tallinn	1826	21
Nairobi	2165	25	Sofia	1824	21
Istanbul	2154	16	Rome	1810	23
Lima	2152	30	Lisbon	1804	22
Kuala Lumpur	2152	17	Rio de Janeiro	1802	30
Singapore	2056	14	London	1787	21
Buenos Aires	2044	17	Moscow	1784	24
Manama	2034	22	Madrid	1782	25
Los Angeles	2022	11	Dublin	1779	22
Auckland	2022	21	Stockholm	1775	25
Budapest	2012	23	Luxembourg	1768	25
Bucharest	1992	20	Sydney	1757	21
Caracas	1989	16	Athens	1744	30
Bogotá	1987	15	Barcelona	1743	30
Tel Aviv	1977	11	Amsterdam	1741	29
Kiev	1958	22	Lagos	1723	31
Shanghai	1958	13	Brussels	1722	22
Prague	1946	22	Milan	1718	23
Sao Paulo	1936	30	Helsinki	1714	28
Lugano	1921	22	Oslo	1703	25
Johannesburg	1910	18	Vienna	1696	26
Toronto	1909	14	Frankfurt	1682	30
Warsaw	1901	26	Berlin	1666	28
Geneva	895	23	Copenhagen	1658	28
Bratislava	1881	19	Paris	1561	26

Source: Prices and Earnings (Zurich: UBS AG, 2003), 23.

relatively less labor and land because of expensive equipment and specialized personnel. In clothing production the most important input factor is that the economy is labor-intensive.

The varying factor inputs and proportions for different commodities, together with the uneven distribution of such factors of production in differ- ent regions of the world, are the basis of the Heckscher–Ohlin theory of factor endow- ment.⁵ This theory holds that the inequality of relative prices is a function of regional factor endowments and that comparative advantage is determined by the relative abundance of such endowments. According to Ohlin, there is a mutual interdependence among production factors, factor movements, income, prices, and trade. A change in one affects the rest. Prices of factors and subsequent product prices in each region depend on supply and demand, which in turn are affected by the desires

of consumers, income levels, quantity of various factors, and physical conditions of production.

Since countries have different factor endow- ments, a country would have a relative advantage in a commodity that embodies in some degree that country’s comparatively abundant factors. A country should thus export that commodity which is rela- tively plentiful (i.e., in comparison to other com- modities) within the relatively abundant factor (i.e., in comparison to other countries). This exported item may then be exchanged for goods that would use large quantities of the country’s scarce factors if domestically produced. Figure 2.3 lists the Netherland’s well-endowed factors, for example. Table 2.4 shows countries with capital scarcity.⁶

Therefore, a country that is relatively abundant in labor but relatively scarce in capital is likely to have a comparative advantage in the production of labor-intensive goods and to have deficiencies in the

Table 2.4 Capital scarcity. Capital endowments and output per capita are much lower in the Central and Eastern European countries than in Western Europe, implying large potential capital inflows into the region.

GDP per worker¹ Relative marginal Potential inflows³

product of capital²

Bulgaria	22.9	19.1	753
Czech Republic	53.6	3.5	275
Estonia	31.1	10.3	543
Hungary	55.7	3.2	259
Latvia	20.9	22.9	825
Lithuania	28.5	12.3	596
Poland	38.6	6.7	425
Romania	26.9	13.8	634
Slovak Republic	42.2	5.6	381
Slovenia	72.8	1.9	147
Median	34.9	8.5	484
Minimum	20.9	1.9	147
Maximum	72.8	22.9	825

Notes

1 In percent of German GDP per worker (purchasing-power-parity basis).

2 Cobb-Douglas production function.

3 In percent of initial (Pre-flow) GDP.

Source: Leslie Lipschitz, Timothy Lane, and Alex Mourmouras, “The Tosovksy Dilemma,” Finance & Development, September 2002, 32.

Figure 2.3 WordPerfect and the Netherlands’ relatively well-endowed factors

Source: Courtesy of the Netherlands Investment Agency and Ogilvy Adams & Rinehart.

production of capital-intensive goods. This concept explains why China, a formidable competitor in textile products, has to depend on US and European firms for oil exploration within China itself.

Each nation possesses factors of production that may be grouped into these broad categories: human resources, physical resources, knowledge resources, capital resources, and infrastructure. Interestingly or surprisingly, a nation’s abundance of a particu- lar production factor may sometimes undermine