CHAPTER 2 REVIEW OF LITERATURE

Transcription

1 CHAPTER 2 REVIEW OF LITERATURE Introduction The factor content studies are centered on the Heckscher-Ohlin (HO) model or its variant Heckscher-Ohlin-Vanek (HOV) model. The HO model is one of the important theoretical models of international trade. However, when taken to the actual data the model was not confirmed usually (Baldwin, 2008). Starting from the seminal study by Leontief (1953), the finding of which did not support the HO prediction regarding the factor content of trade of the US, several other empirical studies conducted on various countries showed that the model did not perform satisfactorily. This generated a great deal of debate leading to theoretical development of the model with modifications of its various assumptions which yielded a complex but empirically more satisfactory framework for understanding patterns of international trade (Baldwin, 2008). This chapter will provide a review of the literature on the factor content of trade. The chapter begins with section 2.1 where a brief discussion on the traditional trade theories is presented. The basic proposition of the HO model and its variant HOV model along with the assumptions are discussed in this section. In section 2.2, Leontief (1953) test and other similar studies have been documented. The following sections 2.3 and 2.4 will review the further developments in this area. 2.1 A Brief Discussion on Traditional Trade Theories In pure theory of international trade, economists attempted to find the answers to the questions, Why and How nations trade. These are the two basic questions that are often asked in this particular branch of economics. Starting from the noted classical economist Adam Smith (1776), several writers offered different theoretical explanations regarding the determinants of the basis and pattern of international trade. Smith explained that at least one and probably all the trading partners can gain from trade if it takes place in accordance with the principle of absolute cost advantage. 13

2 Forty years later Ricardo (1817) contended that it was not the absolute advantage but the comparative advantage that always required trade to occur. Ricardo laid the foundation of the modern trade theory through the development of the notion of comparative advantage which explained that mutually gainful trade can occur between two economies even if one of them enjoys superiority over the other in all lines of production (i.e. enjoys absolute advantage in all lines of production). In his view, a country enjoys comparative advantage in production of a commodity where the degree of superiority over its trading partner is greater than the other commodity. Each country should specialize in production of the commodity in which it enjoys comparative advantage and exports it, in exchange for the commodity where its comparative disadvantage lies. This pattern of trade will lead to increased world output and higher standard of living for both the trading partners (Soderstein, 1980). Ricardo, however, did not investigate in any detail why inter-country differences in comparative advantage occur. It was simply assumed that there are inter-country differences in fixed-coefficient technology (Baldwin, 2008). Thus, the differences in technology across countries can be considered as the implicit reason for beneficial exchange of commodities in the Ricardian model (Feenstra, 2004). A century later Heckscher (1919) and Ohlin (1933) offered a completely different approach to the trade theory focusing on differences in factor endowments among countries as the basis for international trade. Their model, known as Heckscher-Ohlin (HO) model, explains how differences in the relative endowments of factors of production influence the nature of differences in comparative costs between countries under autarky conditions (Baldwin, 2008). The basic proposition relating to the pattern of trade that underlies the HO theorem is: A country will export those goods which intensively use its abundant factors and import those which intensively use its scarce factors. Indirectly, factors which are abundant in supply in a country will be exported (as embodied in goods) and factors in scanty supply will be imported (Ohlin, 1933). In later years two-country, two-good and two- factor version of HO model was formulated which owed much to Stolper and Samuelson (1941), and Samuelson (1948, 1949). This formulation is known as Heckscher-Ohlin-Samuelson (HOS) model. Beside the basic proposition of the model, the HOS model has three other theorems, viz, Factor Price Equalization theorem, Stolper-Samuelson theorem and 14

3 Rybczynski theorem (Baldwin, 2008). Prior to reviewing these three theorems in brief, we state the assumptions on which the HOS model is based. The assumptions of the model are There are two countries, two goods and two factors where each country is endowed with homogenous factors of production, say, capital and labour. The quantities of the factors available in each country are fixed. Each good is produced according to a production function which is assumed to be identical in the two countries. This is one of the most important departures from the Ricardian model of comparative advantage and rules out the possibility that trade is based on technological differences across countries. The production functions for two goods are assumed to show constant returns to scale. The production functions of the two goods differ in their use of capital and labour. In two-factor, two-good framework, if one good is labour intensive the other would be characterized as capital intensive. The factors are perfectly mobile across industries within a country and immobile across countries. The goods are freely traded between countries. There are no market distortions (e.g. taxes, subsidies, imperfect competition, etc) that may affect consumption and production decisions. Preferences in the two countries are assumed to be identical and homothetic. This assumption rules out the possibility that comparative advantage is driven by differences in demand behaviour. Countries are assumed to differ in their relative factor endowments, that is, if in one country capital is relatively abundant in supply; labour would be the relatively abundant factor in the other country. Given the assumption of identical technologies and preferences across countries, this provides the only real difference between the two countries. There exists perfect competition in both commodity and factor markets. There is no Factor Intensity Reversals (FIR). Factor intensity reversal occurs when the factor intensities changes at different factor prices. 15

4 Trade is balanced (i.e. the value of imports and exports are identical). Given these assumptions, two-country, two-good and two-factor version of HO proposition states that the labour abundant country will export labour intensive good while the capital abundant country will export capital intensive good. As mentioned earlier, Factor Price Equalization (FPE) theorem is one of the important corollaries of the HOS model and has relevance in the study of factor content of trade. The theorem says that a tendency towards equalization of relative and absolute factor prices will result from the free movements of goods in international trade. Samuelson (1948, 1949) first rigorously proved that in two-factor, two-good, two-country framework, free trade leads to complete equalization of factor prices under the condition of incomplete specialization. An Integrated World Economy approach (Dixit and Norman, 1980) to FPE shows the following: an international economy has equilibrium with equalized factor prices if and only if the Integrated World Economy has an equilibrium whose output can be produced by the countries each using only its own factor endowments and using integrated world economy technique (FPE condition). The other two important corollaries derivable from the HOS model are Stolper- Samuelson theorem and Rybczynski theorem. Though these two theorems are not directly relevant in the discussion of factor content of trade, for the completeness of the discussion on the HOS model we briefly state them. Stolper-Samuelson (1941) theorem states that an increase in relative price of one of the goods raises the real return of the factor used intensively in the production of the good while decreases the real return of the other factor. The theorem has policy implication. When a country which is, say, relatively labour abundant adopts the policy of import restriction, the domestic price of imported good (capital intensive) rises relative to the price of export good leading to rise in real reward of the country s relatively scarce factor, capital (used intensively in the production of imported good) and fall in real return of the relatively abundant factor, labour. While the Stolper-Samuelson theorem focuses on the factor price effects within a country of a change in relative price of one of the goods produced under fixed factor supply conditions, the Rybczynski (1955) theorem explains the relative output effects within a country of a change in the supply of one 16

5 of its factors of production under fixed relative commodity-price conditions. The theorem states that an increase in the supply of one factor increases the output of the good using this factor intensively and decreases the output of the other good, with prices of goods held constant. Among the assumptions on which the HOS model is based, the assumption of two goods and two factors is the most restrictive one. In the 1960s Travis (1964) and Vanek (1968) extended the two-factor, two-good and two-country framework to a multi-factor, multi-good and multi-country setting, maintaining the basic assumptions of the HO model. In the multi-factor framework the relationship that can be derived with the basic assumptions is that the amount of a particular factor of production embodied in a country s net trade of goods and services equals its endowment of the factor minus its share of world consumption multiplied by the world endowment of this factor (Baldwin, 2008). This relationship implies the basic HO proposition, that is, under balanced trade a country is net exporter of the services of its abundant factors and net importer of the services of its scarce factors, embodied as factor content in the goods they trade. 1 This version of the model does not predict the pattern of trade in individual goods, but does predict the pattern of trade in individual factor services. The HO theory or its variant is one of the most influential ideas in international economics for which the theory has been the subject of extensive empirical testing. The pioneering and elaborate attempt to measure the factor content of trade and thereby test empirical validity of the HO theory was made by Leontief (1953). In subsequent years, several researchers have conducted similar studies on the trade structure of various countries. The following sections will review these empirical studies in detail Leontief (1953) and Other Similar Studies The Pioneering Attempt Leontief (1953) published a paper containing the most notable empirical work on the HO theory. Applying the Input-Output technique and considering two factors of production, capital and labour, Leontief calculated the direct and indirect requirements of labour and capital to produce a representative bundle of one million 17

6 dollars worth of the US exports and a representative bundle of one million dollars worth of domestic goods, directly competitive with the US imports for the year Due to difficulty in availability of foreign data on the capital and labour requirements of actual imports of the US, Leontief got around this issue by estimating the capital and labour requirements of the import competitive industries using the domestic technology coefficient matrix, omitting non-competitive imports from the import basket. Given the capital abundance of the US in the period after World War II, one would expect that the US exports were more capital intensive relative to the US imports, in line with the HO proposition. However, as laid out by Leontief, the actual capital content of the US exports was far lower than that expected (Table 2.1). The study showed that a representative bundle of the US import-competitive goods required 30% more capital per worker than a representative bundle of the US exports. This implied the country exported labour intensive goods and imported capital intensive goods and thereby the US is a nation richly endowed with labour, not capital. This contradiction with the theory is famously known as the Leontief paradox. Table 2.1: Results of Leontief (1953) Test Exports Import Replacements Capital ( $ million) Labour (Person-years) Capital/Labour ($/Person) 13,700 18,200 Source: Compiled from Leontief (1953) The paradox raised lots of criticism and explanations, some of which followed almost immediately. Several economists questioned the statistical procedures adopted or data used in the test. Swerling (1954) argued that 1947 was not a typical year as the postwar reconstruction was yet to be completed by that time. While Buchanan (1955) criticized Leontief s measurement of capital, Loeb (1954) pointed out the differences in capital intensity of export sector and import-competitive sector were not statistically significant. In an attempt to answer his critics, Leontief (1956) repeated 18

7 the test introducing some refinements in the measurements and using the average composition of the US exports and imports for 1951 with I-O table of In this second test the US import substitutes were still found to be more capital intensive than the US exports, confirming the finding of his earlier study. However, in the second study the capital intensity of the US import substitutes exceeded that of the exports only by 6% Other Studies Using Leontief s Methodology The paradox in Leontief s test for the US economy inspired other researchers to make similar investigations on the trade pattern of various other countries around the world. These studies include Tatemoto and Ichimura (1959), Heller (1976), and Yokokawa (1994) on Japan, Stolper and Roskamp (1961) on erstwhile East Germany, Roskamp (1963), and Roskamp and McMeekin (1968) on West Germany, Wahl (1961), and Wu, Thomassin and Mukhopadhyay (2012) on Canada, Hodd (1967) on the United Kingdom (UK), Hong (1975), and Ohno (1988) on Korea, Yokoyama, Ohno, Itoga and Imaoka (1989) on some East and Southeast Asian nations, Baldwin (1971), Stern and Maskus (1981), Lee, Wills and Schluter (1988), and Wolff (2004) on the US economy, Chatterjee (1996) on Australia, Bazzazan (2012) on Iran, Bharadwaj (1962a, 1962b), Bharadwaj and Bhagwati (1967), Prasad (1965), Sengupta (1989), Dasgupta, Dhar and Chakraborty (2009), Dasgupta, Ghosh and Chakraborty (2011), Dasgupta, Ghosh, Chakraborty and Mukhopadhyay (2012), and Sikdar and Chakraborty (2011) on India to name a few. Let us now briefly discuss these studies. Tatemoto and Ichimura (1959) conducted a study on the factor content of foreign trade of Japan for the year He found a dual specialization in the trade structure of Japan. The country was found to be exporting capital-intensive goods to developing countries while exporting labour-intensive goods to developed countries. Since 75% of its exports went to developing countries, Japan exported relatively capital-intensive products and imported relatively labour-intensive products compared to the rest of the world. Capital was a scarce factor in Japan in the year So, this finding suggested the detection of the Leontief paradox for Japan. In another study on Japan, Heller (1976) used the data for the period and information on input-output tables with 60 sectors, considering skill as a separate 19

8 factor in addition to labour and capital. His study further confirmed the dual specialization in Japan s trade as observed by Tatemoto and Ichimura (1959), that is, exports of Japan to developing countries were more capital (and skill) intensive than its exports to developed countries. Moreover, in his study it was found that Japan s export of capital-intensive goods to both developing and developed economies intensified over the period, suggesting a convergence of comparative advantage for Japanese trade. Heller argued that a change had taken place in Japan s factor endowment over the study period which strongly altered the country s comparative advantage in trade. The composition of export bundle shifted towards the capital intensive sectors and the shift was reinforced by a relatively faster deepening in the capital intensity of these sectors. Yokokawa (1994) investigated the factor content for foreign trade of Japan from 1955 to Contrary to Tatemoto and Ichimura s (1959) conclusion on the Leontief paradox in Japan, he argued that Japan was already abundantly endowed with capital and skills from mid-1950s. Stolper and Roskamp (1961) studied the trade pattern of erstwhile East Germany using the Leontief s method. The study revealed that East Germany s exports were more capital intensive than her competitive imports. The result was consistent with the HO model because 75% of East Germany s trade was with the communist block and the country was well endowed with capital as compared to its trading partners. So, there was no evidence of the paradox. Considering two factors of production, labour and capital, Roskamp (1963) estimated the capital intensity of exports and import replacements for trade between West Germany and the US in The results of the study revealed that West Germany s exports were relatively more capital-intensive than those of the US. So, the paradoxical evidence was observed. Roskamp and McMeekin (1968) reconsidered the case of West Germany and included a third factor of production - human capital. They observed that with the third factor of production, the paradox disappeared. In an attempt to study the trade pattern of Canada, Wahl (1961) found that the country s export embodied more capital and less labour than its import replacements in Canada s trade was highly dependent on the US economy. Its exports and 20

9 imports with the US took up to 75% of its total trade value with the rest of the world. If it is assumed that in 1949 the US was relatively more endowed with capital than Canada, the finding by Wahl would suggest another paradox for Canadian trade in More recently, Wu et al. (2012) investigated whether the Leontief paradox existed for Canadian agriculture and processed food trade using the 2006 Input- Output model of Canada. They observed no evidence of the Leontief paradox for Canadian agriculture and processed food trade to the World. Canada was found to export capital-intensive products while importing labour-intensive products. When a third factor, land, was considered, they observed that land was relatively more intensively used in exports than capital. This finding further affirms the assumption of natural resource as being a determinant factor in the structure of Canadian agricultural and processed food trade. Hodd (1967) investigated the trade pattern of the UK with the rest of the world following Leontief. He found that the UK which was more capital abundant than its trading partners, had a higher capital-labour ratio in export relative to import replacements. Thus, Hodd s finding supports the HO proposition for the UK. Hong (1975) and Ohno (1988) analyzed South Korea s trade pattern and determined the country s trade revealed factor abundance. However, their findings differ. Hong concluded that the country was labour abundant in 1970 and capital abundant in In contrast, Ohno (1988) showed that Korea had already become capital-abundant country by Yokoyama, Ohno, Itoga and Imaoka (1989) investigated the paradox for Japan, Korea, Taiwan and Malaysia. They observed that the trade structure of Japan was one of a capital abundant country over the period 1965 to Korea was observed to be capital abundant in 1970 while labour abundant in 1975 which is just opposite to the results observed by Hong (1975). Taiwan and Malaysia were found to be labour abundant countries in 1970 and When labour was classified as skilled and unskilled labour, they observed Japan and Korea were abundant in skilled labour while Taiwan was abundant in unskilled labour. They also showed that natural resource was the most abundant factor in Malaysia followed by labour and capital. So, this study observed no evidences of the Leontief paradox. 21

10 Baldwin (1971), and Stern and Maskus (1981) tested HO theorem on the US economy. Baldwin s investigation conducted with the US I-O table of 1958 and the US trade data of 1962 revealed that the US imports were 27% more capital intensive than the US exports. So, the paradox regarding the US trade pattern continued. Stern and Maskus (1981) estimated the factor requirements of the US exports and import replacements for the years 1958 and 1972 using three factors of production, capital, labour and human capital. The study reaffirmed the paradox for the year 1958 but not for the year 1972 and, therefore, concluded that it might have disappeared by the early 1970 s. As an explanation they argued that the composition of trade had changed during this period. Specially, there had been a decline in the relative importance of the imports of natural resource intensive goods. In a recent work, Wolff (2004) tested the continuation of the Leontief paradox for the US economy over the period He confirmed the paradoxical evidence showing that imports were more capital intensive than exports. However, the capital intensity of exports had been increasing since The study also measured the equipment and R&D intensity of exports and imports. It was observed that imports were more equipment intensive than exports though by 1987 exports had become more equipment intensive than imports. In contrast, the R&D intensity of exports had decreased over the years and by 1996 the R&D intensity of imports was slightly greater than that of exports. After thoroughly investigating the factor content of the US trade he finally affirmed that greater capital intensity of imports than exports and declining R & D intensity of exports were hard to reconcile with the HO proposition regarding the US trade, indicating another evidence of the paradox. Schluter and Lee (1978) measured the labour and capital intensities of the US agricultural trade during 1973, 1974 and The empirical result of the study indicated that the US agricultural exports were more capital intensive while agricultural imports were more labour intensive, a result challenging the Leontief paradox. In another similar kind of work, Lee, Wills and Schluter (1988) examined the Leontief paradox in case of the US agricultural trade considering land along with capital and labour. They observed agriculture trade in the US was more capital and land intensive than labour which confirmed the finding of Schluter and Lee (1978). 22

11 Chatterjee (1996) estimated the factor content of Australia s foreign trade for and considering three factors of production, labour, capital and natural resources. His observation was that Australia exchanged the services of its renewable and non-renewable natural resources and the services of capital to the rest of the world (that these natural resources used as complementary inputs) for the services of labour. He concluded that the findings of the study were largely in keeping with the general perception of Australia as a relatively resource-rich country. So, no paradox was evident. Very recently, Bazzazan (2012) tested the evidence of the Leontief paradox for Iran in the year 2001 considering two factors of production, labour and capital. The result of the study revealed that Iran s exports were more capital intensive and less labour intensive than its import replacements, thus finding another evidence of the paradox. For India also, a few studies have been conducted on measuring the factor intensity of India s foreign trade following Leontief s methodology. Bharadwaj (1962a) empirically tested the HO prediction on the Indian economy for the year He found that India s export used more labour and less capital than that required by the competitive imports, agreeing with the HO proposition. However, when Bharadwaj (1962b) conducted a similar test on India s bilateral trade with the US economy for 1951, the finding did not seem to agree with the theorem. In this study Bharadwaj compared the capital-labour ratio of one million dollars of the US exports to India with one million dollars of the US import replacements from India, and similarly one crore rupees of Indian exports to the US with one crore rupees of Indian import replacements from the US. In respect of the US, the finding of the study was in consonance with general expectation that the US exported relatively capital intensive goods to India and imported relatively labour intensive goods. However, from the Indian side its exports to the US were found to have embodied more capital than labour. So, he observed the paradoxical result. Bharadwaj provided an explanation for this finding. He argued that 1951 was an atypical year in that a large quantity of food grains was imported from the US because of adverse climatic conditions. As agriculture was relatively more labour intensive in India, the over-all labour 23

12 requirements of import replacements were upwardly biased under the identical technology assumption. In another study on India, Bharadwaj and Bhagwati (1967) intended to test the validity of the HO theory incorporating capital intensity adjusted for human capital. Despite the adjustment for human capital, the study observed that India s exports to the rest of the world were relatively more labour intensive than its import replacements. However, the adjustment increased the relative capital-labour ratio of exports. Prasad (1965) extended Bhardwaj s model further by incorporating natural resources as a part of resource endowments to evaluate the Leontief paradox for the year His results also confirmed the prediction of HO theory. Sengupta (1989) tested the factor content of India s foreign trade for the years and and supported the HO presumption relating to India s trade pattern. More recently, Sikdar and Chakraborty (2011) tested empirically the HO model for bilateral trade between two developing countries (India and Sri Lanka) for the year The results showed that exports from India to Sri Lanka were capital intensive and imports from Sri Lanka were labour intensive. Thus, the finding was supportive of the Leontief paradox. The present researcher along with others (Dasgupta et al. 2009, 2011, 2012) estimated the factor requirements of India s exports and import replacements during India s prereform and reform periods using IO tables of , , and along with the trade data of the respective years. They observed that India s exports to the rest of the world were more labour and less capital intensive than its import replacements, which is consistent with the HO proposition regarding India s foreign trade. They further estimated the factor requirements of exports and import replacements of India s bilateral trade with North America over the same period. For pre-reform period and initial decade of the reform period (i.e. the decade of 1990s) the study found that the capital intensity of India s exports to North America was relatively lower than that of import replacements but the result was just reversed in So, the paradoxical evidence was observed for the year Dasgupta et al. (2012) also observed the paradoxical evidences in case of India s trade with the Developing Countries of Asia. 24

13 2.2.3 Other Studies Using Regression Analysis Apart from the studies conducted on the trade structure of the various economies using Leontief s basic methodology, a number of studies investigating the determinants of the structure of a country s trade used regression analysis as an alternative technique. The primary aim of these studies, however, was not to test the empirical validity of the HO model but to assess the relative importance of some of the variables other than capital and labour (Baldwin, 2008). These studies include Keesing (1965), Gruber and Vernon (1970), Hufbauer (1970), Baldwin (1971), Harkness and Kyle (1975), Branson and Monoyios (1977), Stern and Maskus (1981), and Drysdale and Song (2001). Keesing (1965) provided empirical evidence concerning the importance of different relative supplies of labour skill in explaining the structure of the US trade while Gruber and Vernon (1970) showed that the relative importance of R&D activities had a strong positive correlation with the exports of these industries in the US. Hufbauer (1970) applied regression analysis to find out the importance of scale economies as a determinant of the US s structure of trade. He received empirical support for the scale economies. Harkness and Kyle (1975) attempted to measure the simultaneous impacts of a variety of factors in the determination of the US comparative advantages using logit analysis for the year They found that capital intensity had a significant positive impact on the comparative advantage of the US non-natural resource industries whereas it had negative relation with natural resource industries. Using probit analysis Branson and Monoyios (1977) regressed measures of human capital, physical capital and labour for the US net exports of They observed that the sign on the human capital was significantly positive while that on physical capital and labour were significantly negative indicating the importance of human capital in explaining the commodity composition of the US trade. Using probit analysis Stern and Maskus (1981) also found the negative sign for physical capital for the US trade structure in 1958 and 1972 and, therefore, supported the finding of Branson and Monoyios (1977). Stern and Maskus (1981) further showed that with non-resource and resource distinction of industries, as done by Harkness and Kyle (1975), there was a positive relation between physical capital intensity and the probability of nonnatural resource industry being a net exporter. Baldwin (1971) showed that R&D 25

14 activities along with the capital and labour requirements were explanatory factors of the industry pattern of the US trade in the early 1960s. Using regression analysis Drysdale and Song (2001) investigated the comparative advantage for Japanese manufacturing industries by including physical capital, human capital and unskilled labour in their study. They concluded that after mid-1970s physical and human capital exerted significant influence on Japan s comparative advantage Regional Studies So far, we have discussed those studies which had conducted empirical testing of the HO theory for a country as a whole. However, apart from these national tests, a number of studies had conducted regional tests of the HO proposition considering several regions of a country because at the regional level distortions from tariff, import quotas and subsidies would be minimized while the assumptions of identical technology and identical demand would be easily satisfied. These studies include Moroney and Walker (1966), Madresehee (1993), Horiba and Kirkpatrick (1981), and He and Polenske (2004). Moroney and Walker (1966) conducted the first regional test of the HO proposition considering two regions, south and non-south of the US economy. They observed that labour intensive sectors were mostly concentrated in the south which was relatively labour abundant. Considering three factors of production, capital, labour and natural resources, they concluded that the comparative advantage was determined by natural resources followed by capital and labour. Madresehee (1993) conducted a regional test on the Pacific north-west regions of the US and concluded that with relatively lower capital and energy prices and relatively higher labour prices, the country had comparative advantage in energy and capital intensive goods whereas had comparative disadvantage in labour intensive goods. Horiba and Kirkpatrick (1981) conducted another regional study on the US economy taking into account four factors of production, physical capital, human capital, renewable resources and nonrenewable resources. They did not find support for the Leontief paradox as they observed that the regions tended to export those commodities that were intensive in the abundant factor of the regions. More recently, He and Polenske (2004) conducted 26

15 a study on inter-regional trade of Japan. In contrast to earlier studies mentioned before, this study observed the Leontief paradox for some pairs of regions while for some other pairs of regions the HO theorem holds. So, there was mixed evidence of the Leontief paradox Early Explanations to Resolve the Leontief Paradox The frequent evidence on the Leontief paradox cast a doubt on the empirical validity of the theory. This led economists around the world to provide alternative explanations to resolve the paradox. In this section we will discuss these explanations. [A] Differences in Labour Productivity Leontief (1956) himself tried to explain the paradox in terms of differences in labour productivity between the US economy and the rest of the world. According to him the US is a labour abundant country when labour is measured in productivity equivalent units. He argued that the US workers were three times as efficient as her foreign counter parts, attributing the superior efficiency of the US labour to superior entrepreneurship, better economic organization and economic incentives in the US. In favour of this argument he cited the observation of Kravis (1956) that the wages in the US export industries tended to be higher than that in the US import competiting industries. Kreinin (1965) conducted a survey of managers and engineers familiar with production conditions in the US and abroad to find the evidence on Leontief s conjecture. He estimated whether an average American worker was three times more efficient than a foreign worker. He found that a US worker was indeed superior to a foreign worker, but it was superior to its counterpart by 20% -25% only, not three times as claimed by Leontief. Obviously, 20% - 25% difference in efficiency between a representative US worker and a representative foreign worker was not sufficient enough to make the paradox disappear. [B] Human Capital Another explanation of the paradox is in terms of the concept human capital, which refers to education, job training and skills embodied in workers, leading to increase in their productivity. It is well-known that the productivity of labour can be augmented by either utilizing more physical capital per unit of labour, or by combining more 27

16 human capital such as investments in education, public health and so forth, with each unit of labour. Leontief himself alluded to the fact that productivity of labour in America s export sectors was considerably higher than that in the import-competing sectors. This might well be the result of a high rate of investment in human capital in export sector. Thus, the new interpretation of capital where capital was defined as physical capital plus human capital should be an important consideration to determine the US pattern of trade. Kenen (1965), Keesing (1965) and Baldwin (1971) focused their attention on labour skills and human capital for explaining the US trade pattern. Kenen (1965), while asserting human capital as a possible explanation for the paradox, devised an estimate for human capital by capitalizing the income differences between skilled labour and unskilled labour using a 9% rate of discount. After estimating the value of human capital embodied in the US export and import competing sectors and adding them to the estimates of physical capital he arrived at a result where the HO prediction relating to the US pattern of trade survived comfortably, while the Leontief paradox disappeared. However, it was argued that the estimate of human capital was sensitive to rate of discount and if the rate of 9% was replaced by a discount rate of 12.7%, the paradox continued to exist. Focusing on the skill component of labour, Keesing (1965) found that the US exports were more skill intensive than the exports of nine other industrialized countries in The result reflected the fact that the US had the most highly trained labour force, embodying more human capital than other nations. As already stated, Branson and Monoyios (1977) showed the importance of human capital in determining the trade pattern of the US. Baldwin (1971) also argued that excluding natural resource industries was not sufficient to eliminate the paradox unless human capital was included. [C] Factor Intensity Reversals One of the most significant explanations of the Leontief paradox has been stated in terms of factor intensity reversals. An important assumption of the HO theorem is that the factor intensity rankings of commodities do not reverse when factor prices change. This implies that there is no factor intensity reversal (FIR). However, if the 28

17 factor intensity reversals exist, both countries either export labour intensive or capital intensive goods. So, the HO theorem cannot be correct for two countries simultaneously in the presence of factor intensity reversals and one of the two countries should reveal the Leontief paradox. Economists have tried to determine empirically whether the factor intensity reversals are prevalent extensively in the real world and whether they are responsible for the Leontief paradox. The HO theorem should be rejected if the factor intensity reversals are found to be very prevalent. But if it occurs rarely, then we can retain the HO theorem and treat factor intensity reversal as an exception. The first attempt to examine the empirical importance of factor intensity reversals in the real world was conducted by Minhas (1962) using the CES production function or homohypallagic production function [Arrow, Chenery, Minhas and Solow (1961)]. He employed the HO assumption that the same production function exists around the world and computed the CES production function for twenty four industries using data for nineteen countries. On the basis of the estimated values of the parameters of the CES function for these industries, he found factor intensity reversals were quite common in practice. The elasticity of substitution differed between industries and these factor reversals occurred in the empirically relevant range of relative factor prices. Minhas study, though of considerable empirical relevance has not gone unchallenged. It was criticized on technical, mathematical and statistical ground. Using Minhas s data Leontief did some recalculations on the basis of additional information and showed that factor intensity reversals were rather infrequent which implied that the possibility of factor intensity reversals was much less than what Minhas suggested. [D] Natural Resources Leontief s work was criticized on the ground that his investigation was confined to two factors, labour and capital, thus abstracting from other factors such as natural resources. A commodity might be intensive in natural resources so that classifying it as capital or labour intensive would be clearly inappropriate. One early attempt using natural resource as an input into the US exports and imports was made by Diab (1956). This led to a possible explanation for the Leontief paradox which was 29

18 subsequently supported by Vanek (1959, 1963). Vanek found that natural resources were a scarce factor in the US relative to labour and capital. He argued that the US imported a huge amount of natural resource products and production of such natural resource products required large quantities of physical capital. When the US imported natural resource intensive products, it imported large quantities of capital as well (because of a strong complementary relationship between capital and natural resources). Thus, when just two factors, labour and capital, are considered, the US appeared to be importing capital-intensive goods. In an attempt to explain the paradox by taking into account the natural resources, Hoffmeyers (1958) excluded the natural resource intensive products from calculation of capital labour ratios and found Leontief s conclusion reversed. Leontief (1956) also recalculated the factor content of US trade after excluding the natural resource industries and succeeded in reversing the paradox. He showed that capital intensity of the US exports exceeded that of the import replacements when natural resource products were excluded. As mentioned earlier, Baldwin (1971), however, found that when such products were eliminated, the capital intensity of US import replacements had dropped substantially but not enough to dispel the paradox. His finding thus reflected that definitions of natural resource industries were arbitrary and critical to obtaining or dispelling the paradox. [E] Demand Bias There may be other reasons why Leontief s finding contradicts the HO conclusion. A country s demand conditions play a significant role in shaping its export or import pattern. If demand conditions in the country are biased towards the goods, using intensively its abundant factor, the country may actually import that good. The US economy, even though capital abundant, may have a strong demand for capital intensive goods relative to other countries. Valavanis-Vial (1954), Robinson (1956) and Jones (1956) hold that the Leontief paradox might be the result of American demand pattern being biased towards capital-intensive goods. The relevant question here is when can such demand bias exist? This could be possible when the different trading countries have identical tastes but different per capita income levels. 30

19 If capital intensive goods have income elasticity greater than one and labour intensive goods have less than one, then in a capital abundant country with higher per capita income, relative price of capital intensive goods may have relatively higher in the absence of trade due to demand outweighing supply. When trade is opened up, the country will import capital intensive goods, as its price is relatively lower under autarky. This is how the paradox can be explained. However, this is a theoretical explanation because no conclusive evidence to support the contention that capital rich countries have a disproportionate tendency to consume capital intensive goods, has yet been obtained. Brown (1957) observed that the US consumption pattern tended to be biased towards labour intensive goods and not towards capital intensive goods. Houthakker (1957) also showed that there was considerable similarity in demand functions among the countries. Some argued that people tended to spend more on labour intensive goods such as service-oriented sectors with the increase in per capita income. Hence, if there was indeed a consumption bias in the US, the bias must be towards labour intensive goods rather than capital intensive goods. [F] Trade Distortion Measures (Tariff and Other Distortions) The HO theory predicts trade patterns from factor endowments on the assumption of free play of market forces and non-interference by the government. But when Leontief conducted his empirical test, the US trade structure was highly protected. Travis (1964) argued that tariff and non-tariff barriers might have been responsible for the Leontief paradox. The US tariff heavily protected domestic importcompetiting sectors requiring large quantities of unskilled labour. High tariff rates on the products of such industries precluded their imports and consequently carried very small weights in determining the average labour requirements of US importcompetiting sector. Travis contented that the existing tariff could be an exclusive explanation of the paradox. Baldwin (1971) made an experiment on this issue. He found that if all tariff and nontariff barriers were reduced to zero, the capital labour ratio of the US imports would fall by only 5%. This was not sufficient enough to make the paradox disappear. Another kind of distortions stemming from market imperfection has been put forward by Diab (1956). He suggested that production by large American multinational 31

20 corporations and their subsidiaries should be considered as an extension of the US economy. These corporations employed highly skilled technicians, managers, US capital and technology and were, therefore, very capital intensive. These American Economic Colonies should be incorporated into the mother economy of the US. When shipments to the US were regarded as part of US internal trade rather than US import, the capital intensity of the US trade with the rest of the world might be reversed and thus could explain the paradox. Table 2.2 documents the studies discussed so far in a summary form. Table 2.2: Factor Content Studies Based on the Leontief Method and the Regression Analysis Sl Studies Country Year Result no. 1 Leontief (1953) US 1947 IO Paradox table and 1947 trade data 2 Leontief (1956) US 1947 IO Paradox table and 1951 trade data 3 Hoffmeyers (1958) US 1947 Confirms HO theory with third factor natural resources, No paradox 4 Tatemoto and Japan 1951 Paradox Ichimura (1959) 5 Stolper and Roskamp (1961) East Germany 1950 Confirms the HO theory, No paradox 6 Wahl (1961) Canada 1949 Paradox 7 Bharadwaj (1962a) India Confirms the HO theory, No paradox 8 Bharadwaj (1962b) India IO Paradox with US table and 1951 trade data 9 Roskamp (1963) West 1954 Paradox 10 Vanek (1959, 1963) Germany US 1947 Confirms HO theory with third factor natural resource, No paradox 11 Prasad(1965) India Confirms the HO theory, No paradox 12 Kenen (1965) US 1957 Confirms the HO theory with third factor skilled labour, No paradox 13 Keesing (1965) US 1957 Confirms the HO theory with third factor skilled labour, No paradox 14 Moroney and Walker (1966) Regional test on US 1952 Paradox 15 Bharadwaj- India Confirms the HO theory, No Bhagwati (1967) paradox 16 Hodd (1967) UK 1947, 1948 Confirms the HO theory, No 32

21 paradox 17 Roskamp and McMeekin (1968) West Germany 1954 Confirms HO theory with third factor human capital, No paradox 18 Baldwin (1971) US 1962 Paradox 19 Hong (1975) South Korea 1970, 1975 labour abundant in 1970 and capital abundant in Heller (1976) Japan Paradox 21 Stern and Maskus (1981) US 1958, 1972 Paradox in 1958, Confirms the HO theory in 22 Horiba and Kirkpatrick (1981) 23 Schluter and Lee (1978) Regional test on US US 1973, 1974 and (No paradox) 1963 Confirms the HO theory, No paradox Confirms the HO theory, No paradox 24 Lee, Wills and Schluter (1988) US 1978 Confirms the HO theory, No paradox 25 Ohno (1988) Korea 1970 Capital abundant country in Sengupta (1989) India , Confirms the HO theory, No paradox 27 Yokoyama, Ohno, Itoga and Imaoka (1989) Japan, Korea, Taiwan and 1965, 1970, 1970 Confirms the HO theory, No paradox Malaysia 28 Madresehee (1993) Regional test on US 1981 Confirms the HO theory, No paradox 29 Yokokawa (1994) Japan Paradox 30 Chatterjee (1996) Australia , Wolff (2004) US Paradox 32 He and Polenske Regional (2004) test on 33 Sikdar and Chakraborty (2011) 34 Dasgupta, Dhar and Chakraborty (2009) 35 Dasgupta, Ghosh and Chakraborty (2011) 36 Dasgupta, Ghosh, Chakraborty and Mukhopadhyay (2012) Japan India with Sri Lanka India , , , India , , , India , , , , Confirms the HO theory, No paradox 1985 Mixed evidence on the paradox Paradox 37 Bazzazan (2012) Iran 2001 Paradox 38 Wu, Thomassin and Mukhopadhyay (2012) Source: Prepared by the Author India with the ROW: no paradox, India with North America: Paradox India with the ROW: no paradox, India with North America: Paradox India with the ROW: no paradox, India with North America: Paradox India with the Developing Countries of Asia: Paradox Canada 2006 Confirms the HO theory, No paradox 33

22 The Leontief paradox sparked the search of a theory that could explain it. However, the economists were not satisfied with the explanations and the search continued. In the 1980s, in a highly influential paper, Leamer (1980) added a new dimension to the literature on the factor content of trade and empirical testing of the theory by criticizing the basic methodology of Leontief in determining the trade revealed factor abundance of a country, which we will next turn to Leamer s Critique Leamer (1980) argued that Leontief test was based on a wrong proposition and the paradox would disappear if conceptually correct calculations were used to measure the factor content of trade. He was the first to point out that it was inappropriate to compare the capital and labour embodied in exports and import substitutes without taking into account the trade balance situation. Considering two factors, capital and labour, in the HOV framework, he showed that a capital abundant country having a sufficiently large trade surplus with the rest of the world might be net exporter of both the factor services. Leamer argued that in cases where a country is net exporter (due to trade surplus) or net importers (due to trade deficit) of both the factor services, Leontief s approach, that is, the comparison between the factor content of exports and that of imports, might not be the correct proposition to conclude on whether the paradox exists or not. He further showed that in such situations the correct comparison should be between the factor content of domestic consumption and that of net exports. Leamer described three possible situations to determine the trade revealed factor abundance and thereby conclude on whether the paradox exists or not. First, if the net factor content of trade has opposite signs, that is, if capital is net exported and labour is net imported, the country would be revealed abundant in capital. Second, if both the factors, labour and capital, are net exported, the country is capital abundant if the capital-labour ratio embodied in net trade is greater than the capital-labour ratio embodied in domestic consumption. Third, if the country is net importer of both the factor services, then the country is capital abundant if the capital-labour ratio in net trade is lower than the corresponding ratio in domestic consumption. 2 34