Early models of international trade such as Adam Smiths theorising of Abolute advantage followed by the classical Ricadian model served well to deconstruct a complex reality in order to understand the mechanisms at work. The concept of deconstructing reality is invaluable; despite this the early models suffered from a multitude of unrealistic assumptions and are now dated in explaining the behaviour of modern multinational corporations (MNC’s).
Two economists, Heckscher and Ohlin, proposed the Heckscher-Ohlin model (the HO model), recognising that the production of goods requires certain inputs such as labour, land or capital, which they termed “factors”. Each country will have a relative abundance of these factors, for example, the US traditionally is abundant in capital whereas China is, traditionally, abundant in Labour. They theorise that countries will produce, and export those goods in which they have relative factor abundance, importing those in which factors are scare. This model however has several flaws in predicting reality; the most noted being a practical application by Wassily Leontief (1953), termed the Leontief paradox. The Leontief paradox describes a phenomenon in which, although the US it the most capital abundant in the world, it imports capital intensive goods, and exports labour intensive goods. Leontief found that, in 1947, the US had net imports of £540559 and exported 12309 man hours of labour (Leontief. W -1953), this implies that in aggregate companies were producing an excess of labour intensive goods and exporting them. Contrary to what the theory would predict. Additionally a number of assumptions are made such as equal production technology and that all labour is equal; this is clearly not the case and the latter is addressed in a later model. It also assumes that there is no cost of transferring between labour and capital; this affects the models ability to predict MNC behaviour greatly as there is a large cost in investing in capital which will often not become profitable for years. MNC’s are aware of this and so their decision may differ from the outcome predicted by the HO model by choosing a strategy which does not require risky investment in capital. Another assumption made is that factors are immobile; this is at odds with the cluster phenomenon, a geographic concentration of an industry, observed in reality, presenting another flaw with the HO model. Clusters are likely to affect where MNC’s base their production, for example Texus Instraments the company which manufactures part of the iPhone (PK. The Economist – 2011) is based in the technology cluster Silicon Valley. Finally, the HO model assumes there are no transport costs, although these costs have reduced dramatically recently, they still have an effect on where production is based, for example the majority of the factories producing for MNC’s in China are based along the coastline (C. Zhou, A. Delios & J Y. Yang - 2002) to reduce transport costs. As the HO theory does not account for these transport costs it would provide no predictive power over the location of these facilities. Applying the HO model to a MNC’s choice of where to base production we would expect to see labour intensive goods produced in labour abundant countries. Using World Input Output Data (Timmer. M P. - WIOD) from 2011 to analyse a classic example of a capital rich country, the US, and the rest of the world (ROW), in trade of a labour intensive good, textile production, and a relatively capital intensive good, electronic equipment. As Table 1 shows, the US has a much higher proportion of capital intensive goods compared to the ROW while the ROW has a larger proportion of labour intensive outputs. This suggests some parallels between the