Factor Endowment Theory

The factor endowment theory holds that countries are likely to be abundant in different types of resources. In economic reasoning, the simplest case for this distribution is the idea that countries will have different ratios of capital to labor. Factor endowment theory is used to determine comparative advantage. The Hechsher-Olin Theory holds that a country will have a comparative advantage in the good that uses the factor with which it is heavily endowed. When calculating comparative advantage, it is essential to remember that it is the ratios of factors that matter; a country could be heavily endowed with both labor and capital, but it proportionally may have more of one than another than would another country. If a country has a comparative advantage in a good that uses the factor with which it is heavily endowed, it should focus it's production on that good. Because it is heavily endowed with that factor, it will be most efficient at producing the good that requires that factor for production. For example, a country with a high ration of capital to labor will be more efficient at producing computers than it would corn. If that country instead focused on producing corn, it would have to divert capital which is not meant for corn production into an area where it is inefficiently used.

Critiques of the Factor Endowment Theory

The factor endowment theory, while used to explain overarching notions of comparative advantage, in reality only accounts for a small percentage of world trade. At one time, there were big disparities between labor and capital in the US and East Asia. East Asia began to grow much faster than the US, however trade increased as the two countries became more similar, even though the factor endowment theory would predict that trade should have lessened. This suggests that there must be something other than factor endowments motivating international trade. The assumptions that drive the factor endowment theory may be flawed. It first assumes the same technology, and also assumes arbitrary borders. However, factors like borders play a large role in how much trade occurs; Seattle, for instance, conducts more trade with Boston than it does with Vancouver. Branding also plays a large role in trade; France has been very successful in differentiating its product, wine, from that of other countries, so regardless of factor endowments France will likely continue to specialize in wine and the rest of the world will likely keep buying it from them.