The Leontief Paradox

The Heckscher-Ohlin theory has been one of the most influential theoretical ideas in international economics. Most economists prefer the Heckscher-Ohlin theory to Ricardo's theory because it makes fewer simplifying assumptions. It has been subjected to many empirical tests. Beginning with a famous study published in 1953 by Wassily Leontief (winner of the Nobel prize in economics in 1973), many of these tests have raised questions about the validity of the Heckscher-Ohlin theory.¹² Using the Heckscher-Ohlin theory, Leontief postulated that since the United States was relatively abundant in capital compared to other nations, the United States would be an exporter of capital-intensive goods and an importer of labor-intensive goods. To his surprise, however, he found that US exports were less capital intensive than US imports. Since this result was at variance with the predictions of the theory, it has become known as the Leontief paradox.

Why do we observe the Leontief paradox? No one is quite sure. One possible explanation is that the United States has a special advantage in producing new products or goods made with innovative technologies. Such products may be less capital intensive than products whose technology has had time to mature and become suitable for mass production. Thus, the United States may be exporting goods that use skilled labor and innovative entrepreneurship, while importing manufactures that use large amounts of capital. More recent empirical studies tend to confirm this.¹³ Recent tests of the Heckscher-Ohlin theory using data for a large number of countries tend to confirm the existence of the Leontief paradox.¹⁴

This leaves economists with a difficult dilemma. They prefer Heckscher-Ohlin on theoretical grounds, but it is a relatively poor predictor of real-world international trade patterns. The theory they regard as being too limited, Ricardo's theory of comparative advantage, actually predicts trade patterns with greater accuracy. The best solution to this dilemma may be to return to the Ricardian idea that trade patterns are largely driven by international differences in productivity. Thus, one might argue that the United States exports commercial aircraft and imports automobiles not because its factor endowments are especially suited to aircraft manufacture and not suited to automobile manufacture, but because the United States is more efficient at producing aircraft than automobiles.

The Product Life-Cycle Theory

Raymond Vernon initially proposed the product life-cycle theory in the mid-1960s.¹⁵ Vernon's theory was based on the observation that for most of the 20th century, a very large proportion of the world's new products had been developed by US firms and sold first in the United States (e.g., mass-produced automobiles, televisions, instant cameras, photocopiers, personal computers, and semiconductor chips). To explain this, Vernon argued that the wealth and size of the US market gave US firms a strong incentive to develop new consumer products. In addition, the high cost of US labor gave firms an incentive to develop cost-saving process innovations.

Just because a new product is developed by a US firm and first sold in the United States, it does not follow that the product must be produced in the United States. It could be produced abroad at some low-cost location and then exported back into the United States. However, Vernon argued that most new products were initially produced in America. Apparently, pioneering firms believed it was better to keep production facilities close to the market and to the firm's center of decision making, given the uncertainty and risks inherent in new-product introduction. Because the demand for most new products tends to be based on nonprice factors, firms can charge relatively high prices for new products, which obviates the need to look for low-cost production sites in other countries.

Vernon went on to argue that early in the life cycle of a typical new product, while demand is starting to grow rapidly in the United States, demand in other advanced countries is limited to high-income groups. The limited initial demand in other advanced countries does not make it worthwhile for firms in those countries to produce the new product, but it does necessitate some exports from the United States to those countries.

Over time, demand for the new product starts to grow in other advanced countries (e.g., Great Britain, France, Germany, and Japan). As it does, it becomes worthwhile for foreign producers to begin producing for their home markets. In addition, US firms might set up production facilities in those advanced countries where demand is growing. Consequently, production within other advanced countries begins to limit the potential for exports from the United States.

As the market in the United States and other advanced nations matures, the product becomes more standardized, and price becomes the main competitive weapon. As this occurs, cost considerations play a greater role in the competitive process. One result is that producers based in advanced countries where labor costs are lower than in the United States (e.g., Italy, Spain) might now be able to export to the United States.

If cost pressures become intense, the process might not stop there. The cycle might be repeated once more, as developing countries (e.g., Thailand) begin to acquire a production advantage over advanced countries. Thus, the locus of global production initially switches from the United States to other advanced nations, and then from those nations to developing countries.

Over time, the United States switches from being an exporter of the product to an importer of the product as production becomes concentrated in lower-cost foreign locations. These dynamics are illustrated in Figure 4.5, which shows the growth of production and consumption over time in the United States, other advanced countries, and developing countries.

Figure 4.5  see

The Product Life-Cycle Theory

Source: Adapted from R. Vernon and L. T. Wells, The Economic Environment of International Business, 4th ed. (Englewood Cliffs, NJ: Prentice-Hall, 1986).