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

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

Table 2.3 Working hours and vacation days around the globe

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

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

instead of enhance the country’s competitive advantage.7

The quality of human resources is a function of human development. The United Nations Develop- ment Program has prepared the Human Devel- opment Index (HDI) to measure well-being.8 The HDI, ranging from zero (low human development) to one (high human development), is an arithmetic average of a country’s achievements in three basic dimensions: longevity (measured by life expectancy

at birth); educational attainment (measured by com- bination of adult literacy rate and enrollment ratio in primary, secondary, and tertiary education); and living standards (measured by GDP per capita in US dollars at purchasing power parity). Both the HDI and per capita income are highly correlated with the other widely used measures of poverty. Table 2.5 shows a list of countries based on the HDI.

Date: 2014-12-21; view: 1532