Factor Endowment

An Approach to Explain Nations' Comparative Advantages

Several theories and empirical analyses in international trade have been advanced to explain why trade takes place among countries.

Most economists have followed the neo-classical explanation and believe that factor endowment go a great way to explain international trade patterns.

Factor endowment can be defined as the quantity and quality of the factors of production—land, labor, capital and natural resources—that a nation possesses.

The Heckscher-Ohlin (H-O) theory Opens in new window, which expanded and elaborated on David Ricardo’s theory of comparative advantage Opens in new window, ties the theory of comparative advantage to factor endowment.

It proposes that goods can be produced with differing proportion of factors and that factors are mobile between sectors but immobile between countries.

According to the H-O theory of international trade, a country will be able to produce at a lower cost (and therefore have a comparative advantage Opens in new window in) those products whose production requires relatively large amounts of the factors of production (that is, factor endowments) with which the country is relatively well endowed.

For instance, countries with relatively large amounts of land relative to other factors (for example, Australia, Canada) will have a comparative advantage in producing goods that require relatively large amounts of land for efficient production (for example, wheat).

We also expect Hong Kong, for example, to have a comparative disadvantage in wheat production. It is also implied that countries that have labor forces that are large (labor abundant) relative to their capital stocks will have low wages relative to interest payments (that is, the returns to capital).

Because countries differ in their endowments of factors of production and goods differ in the factor mixes with which they can be produced, these differences affect costs in individual industries.

For example, countries with a lot of capital are the most efficient in the production of capital-intensive goods, while countries with a lot of fertile land are the most efficient in the production of agricultural products, for example, foodstuffs and raw material inputs.

For the United States (and most advanced countries) the capital/labor ratio is expected to range widely from a low in the apparel/textile industry to a high in the petroleum and chemical industries. Over time, the capital/labor ratio is expected to rise in all industries, but the ratio is not expected to show any dramatic change.

Nation’s endowments with factors of production change over time, but generally we expect the industrialized countries, on the one hand, to be well endowed with capital and less so with unskilled labor.

Development countries, on the other hand, are well endowed with labor and less so with capital. Accordingly, international trade takes place as a result of these differences in factor endowments and, by implication, the greatest benefit from trade will be derived from those between the industrialized and developing countries.

In terms of the distribution of factors among countries, Australia and Canada are rich in fertile land and have a comparative advantage in grain-growing, whereas countries like Japan, Sweden, Belgium and the Netherlands are well endowed with capital and have a comparative advantage in capital-intensive industrial commodities.

The capital/labor ratios of countries show that Switzerland and Germany are among the most capital endowed countries of the world. Not surprisingly, there seems to be a correlation between capital abundance and economic development. The poorest countries have the lowest capital/labor ratios.

The factor endowments argument to trade quickly became popular because of its simplicity, logical completeness and ease of manipulation.

It also has the capacity of providing important insights into the effects of international trade on factor prices (for example, wages) and the impact of economic growth on the pattern of international trade, and of explaining the socio-political behavior of various interest groups in an economy.