Leontief Paradox and Development of Trade Theory

1. Leontief Paradox and Development of Trade Theory

2. W. W. Leontief was an economist who won a Nobel Prize in Economics in 1973 for his work on input-output tables. Input-output tables analyze the process by which inputs from one industry produce outputs for consumption or for inputs for another industry. With the input-output table, one can estimate the change in demand for inputs resulting from a change in production of the final good. Wassily Wassilyovitch Leontief (1905~1999) Leontief used input-output analysis to study the characteristics of trade flow between the U.S. and other countries, and found what has been named Leontief's paradox; "this country resorts to foreign trade in order to economize its capital and dispose of its surplus labor, rather than vice versa, i.e., U.S. exports were relatively labor-intensive when compared to U.S. imports. This is the opposite of what one would expect, considering the fact that the U.S.'s comparative advantage was in capital-intensive goods.

3. Science or Pseudoscience • The significance of any theory consists in the fact that the theory must be a faithful representation and a scientific summation of the specific practices. In addition such scientific theory could be used to effectively guide the actual performances and development of the practices. • Otherwise, if the theory separates far away from the actual practices, the so-called theory must be either one of the following two cases: • (1) There is no necessity for the theory to continuously exist or it would have been a pseudoscience; • (2) It must be necessary to revise or readjust the theoretical assumptions on which the theory had been established so that the theory could maintain its rational crux on the even more scientific basis.

4. Development of Theory • To abandon the pseudoscience and the processes of re-examining the theoretical assumptions represent development and refinement of a particular theory. • All of these should be done on the basis of empirical test of the theory. • In other words, there is no need to have a superstitious belief in the existing conclusions of any theory. • On the contrary, in order to have the theory developed and refined, it is necessary to execute empirical test of it.

5. Empirical Test of Factor Endowment Theory • The principle of comparative advantages derived from classical Ricardian model performs as the theoretical base of factor endowment theory introduced by Heckscher and Ohlin, the main trend of international trade theory. • In other words, since the comparative advantages, no matter from where they come, function as the most important theoretical pre-requisites of international trade, economists have been interested in the extent to which the general conclusions of Ricardian model and “H-O Model” are realized in international trade. • In particular, economists focused on if a country’s trade reality consistent with the basic principles of factor endowment theory.

6. The Stare Tongue-tied Discovery by Leontief • Throughout his life Leontief campaigned against “theoretical assumptions and non-observed facts” (the title of a speech he delivered while president of the American Economic Association, 1970-1971). • According to Leontief too many economists were reluctant to “get their hands dirty” by working with raw empirical facts. To that end Wassily Leontief did much to make quantitative data more accessible, and more indispensable, to the study of economics. • In a 1953 article by Leontief showed, using input-output analysis, that U.S. exports were relatively labor-intensive compared to U.S. imports. • This was the opposite of what economists expected at the time, given the high level of U.S. wages and the relatively high amount of capital per worker in the United States. Leontief’s discovery was termed the Leontief Paradox.

7. Leontief’s First Test One million dollars' worth of typical exportable and importable in 1947 (K/L)x = Kx / Lx = $14,300 (K/L)m = Km / Lm = $18,200 The US is believed to be endowed with more capital per worker than any other country in the world in 1947. Thus, the H-O theory predicts that the US exports would have required more capital per worker than US imports. However, Leontief was surprised to discover that US imports were 30% more capital-intensive than US exports, (K/L)m = 1.30 (K/L)x . (See: W. Leontief, Domestic Production and Foreign Trade: The American Capital Position Re-examined, Proceedings of the American Philosophical Society 97, September 1953.)

8. Leontief’s Second Test One million dollars' worth of typical exportable and importable in 1951 (K/L)x = Kx / Lx = $12,970 (K/L)m = Km / Lm = $13,711 (K/L)m = 1.057 (K/L)x In 1956 Leontief repeated the test for US imports and exports which prevailed in 1951. In his second study, Leontief aggregated industries into 192 industries. He found that US imports were still more capital-intensive than US exports. US imports were 5.7% more capital-intensive. The degree had been reduced but the paradoxical conclusion remained. (See: W. Leontief, Factor Proportions and the Structure of American Trade: Further theoretical and empirical analysis, Review of Economics and Statistics 38, no. 4 November 1956.)

9. Leontief’s Comments on His Discovery Facing such a stare tongue-tied paradoxical conclusion Leontief surprisingly pointed out: • “These figures show that an average million dollars’ worth of our exports embodies considerably less capital and somewhat more labor than would be required to replace from domestic production an equivalent amount of our competitive imports”. • “ America’s participation in the international division of labor is based on its specialization on labor intensive, rather than capital intensive, lines of production”. • “In other words, this country resorts to foreign trade in order to economize its capital and dispose of its surplus labor, rather than vice versa”. • “The widely held opinion that—as compared with the rest of the world—the United States’ economy is characterized by a relative surplus of capital and a relative shortage of labor proves to be wrong. As a matter of fact, the opposite is true”. Who can tell me who I am?

10. One million dollars' worth of typical exportable and importable in 1962 • Baldwin Test (See: Robert E. Baldwin, Determinants of the Commodity Structure of U.S. Trade, American Economic Review 61, no. 1 March 1971.) (K/L)x = Kx / Lx = $14,321 (K/L)m = Km / Lm = $17.916 (K/L)m = 1.251 (K/L)x Professor Robert E. Baldwin (1971) used the 1962 US trade statistics to almost entirely repeat what Leontief did by using the data of 1947 and 1951. Baldwin found that capital/labor ratio for US exports was about $14200 whereas capital/labor ratio for US imports was about $18000. In other word taking US trade in 1962 into consideration US imports were 26.8% more capital-intensive than US exports while US exports were 26.8% more labor intensive than US imports. Fifteen years past but the paradox continued.

11. Other Empirical Tests after Leontief • Test of Tatemoto and Ichimura (See: M. Tatemoto and S. Ichimura, Factor Proportions and Foreign Trade: The Case of Japan, Review of Economics and Statistics, no 41 November 1959)----Paradox Exists. • Test of Stolper and Roskamp (See: Wolfgang F. Stolper and Karl Roskamp, "Input-Output Table for East Germany, with Applications to Foreign Trade." Bulletin of the Oxford Institute of Statistics, November 1961.) ----No Paradox. • Test of Wahl (See: D. F. Wahl, "Capital and Labor Requirements for Canada's Foreign Trade," Canadian Journal of Economics and Political Science, August 1961.)---- Paradox Exists. • Test of Bharadwaj (See: R. Bharadwaj, Factor Proportions and the Structure of India-U.S. Trade, Indian Economic Journal, October 1962.)---- Paradox Exists.

12. Effect of Different Labor Efficiency • Leontief himself favored H-O theory. He tried to provide some explanation by stressing the different efficiency in the US and the other countries. • He argued that US workers might be more efficient than foreign ones. As Leontief suggested that perhaps U.S. workers were three times as effective as foreign workers. • He said in his paper “in any combination with the given quantity of capital, one man-year of American labor is equivalent to, say, three man-years of foreign labor”. It means that the average American worker is three times as effective as he would be in the foreign country. • Given the same K/L ratio, Leontief attributed the superior efficiency of American labor to remarkable entrepreneurship（卓越的企业家精神）, superior economic organization（一流的管理组织）and environment full of economic incentives（充满激励机制的工作环境）in the U.S. • However, Leontief found very few followers among economists. Even Leontief himself submitted that he had made a plausible alternative assumption（一个貌似合理实为巧言诡辩的假定）

13. Factor Intensity Reversal See: B. S. Minhas: The Homohypallagic Production Function, Factor-Intensity Reversals and Heckscher-Ohlin Theorem（同步置换生产函数、要素密集转换和赫克歇尔俄林命题）, Journal of Political Economy 70, no.2, April 1962. If a commodity is produced by a labor-intensive process in the labor-rich country and also by the capital-intensive process in the capital-rich country, then factor intensities are reversed in the production of that commodity. A capital abundant Country A and a labor abundant Country B will respectively make production decisions following the law of economic efficiency. But factor intensity reverses. Actually, these two countries seldom trade with each other, instead, they both export their comparatively advantageous goods to the third country.

14. Agriculture is labor-intensive in India but capital-intensive in the United States. Since India is surely a labor abundant country agricultural production in India must be a typical labor-intensive process. While because of very relatively high wage rate and a relatively low price of capital the United States tends to substitute labor input with a great deal of agricultural machinery. If the United States imports agricultural products from abroad, then it looks like to import some capital-intensive goods, a Leontief paradox occurs in the US, because a false appearance shows that a capital abundant country is importing capital-intensive products. If the United States exports agricultural products to India, that is true in the US-Indian bilateral trade, then a Leontief paradox occurs in India, because a widely recognized labor-abundant country, India, is importing some labor-intensive goods.

15. Natural Resources • See: Jaroslav Vanek, The Natural Resource Content of the United States Foreign Trade 1870-1955, Cambridge, MA: MIT Press, 1963. • Jaroslav Vanek argued that Leontief may have oversimplified the production functions and failed to recognize the endowments of natural resources. With three factors of production, the typical H-O model does not predict much. This is because the notion of abundance and intensity must be redefined. • Let N stands for natural resources we could have some N-abundant and N-scarce countries. Also we could have N-intensity good. • If an N-abundant country exports N-intensive good while an N-scarce country imports N-intensive good, no Leontief Paradox.

16. Relations between natural resources and capital inputs • In the actual production processes of natural resource-intensive goods there must be complementary relations between natural resources inputs and capital inputs and in the most part of such production processes capital and natural resources cannot be substituted for each other. • The so-called N-intensive goods are basically produced in considerably capital-intensive methods. • Typical natural resource intensive good, petroleum and oil products, in every stage of the production processes, including exploitation, extraction, refinement, transportation, as well as manufacturing, storing (usually tanking) and carriage (usually piping) of different types of oil products (gasoline, diesel, natural gas, and so on) a large volume of capital in terms of an array of specific machinery and equipments must be used. • It is impossible for a country with an abundant capital endowment, such as the United States, to substitute the relatively expensive precious natural resources with the relatively cheap capital inputs.

17. US Trade Pattern Consistent with H-O Model There are at least two reasons for the US to import large volume of N-intensive goods. • Economic consideration. To import such goods from abroad must be considerably cheaper than to domestically produce them. • Strategic consideration. To establish the national strategic reserve of some important natural resources is to the national benefit of the United States. • As an “N-scarce” country the US naturally imports a great volume of N-intensive goods from abroad. No paradox here. • Because of the specific relation between natural resources and capital inputs the US seems to import capital-intensive goods if we have no consideration of natural resources when analyzing its trade pattern. • Leontief Paradox is nothing but a misunderstanding.

18. Human Capital • Nations and individuals invest in their future not only by accumulating physical capital, such as plant buildings, equipments, and inventories, but also by spending on education, training, and other investments that are embodied in human form, that is, human capital. • Human capital investment acquires an appropriate rate of return in terms of relatively higher wage rate. • The general level of wage rate is higher in those industries in which human capital is employed in a relatively larger proportion. • Equivalently, higher wage rate of a particular country means it must be endowed with relatively abundant human capital because of the developed higher learning education and the advanced social service system. Old Campus of Yale University See: Irving Kravis, Wages and Foreign Trade, Review of Economics and Statistics 38, February 1956 and Peter. B. Kenen, Nature, Capital and Trade, Journal of Political Economy 73, October 1965.

19. False Appearance Makes the Paradox • When we insert a new factor of human capital into the trade model, trade pattern of the United States must be completely reexamined. • At first, the US must be regarded as to be abundant in human capital endowment. The relevant statistics suggest that a typical US laborer has an average more years of education than a foreign worker. Thus the US laborers earn a relatively higher salary than their foreign competitors. • Taking advantages of its abundant human capital the US may have been exporting human capital-intensive goods to the other countries. Such sorts of the US trade is consistent with the basic prediction of the H-O theory no paradox at all. • Unfortunately, the effect of human capital, generally higher wage rate had been falsely concluded as more labor input by Leontief. That false appearance must be the reason for Leontief Paradox. • Peter Kenen in 1965 calculated the value of extra human capital and reexamined trade pattern of the US. He suggested that if the value of human capital were included, the US exports were capital-intensive relative to US imports. This would reverse the Leontief paradox.

20. Skills of Labor • A nation’s labor force is far from homogeneous but rather consists of many skill groups. Some economists, such as Donald Keesing, have sought the explanation of trade patterns in endowments of skills. • The basic point is that the use of labor as factor of production may involve a category that is too aggregative, since there are many different kinds and qualities of labor. • Keesing divided the US labor in production into the following eight different categories (They are listed in a descending order of skills): 1. Scientists and Engineers ; 2.Technicians and Draftsmen; 3.Other Professional; 4. Managers; 5.Skilled Laborers; 6.Other Skilled Handworkers; 7.Marketing Personnel and 8.Semiskilled and Unskilled Laborers. Keesing argued the first seven categories could be skilled labor while the last category must be unskilled labor. • In addition Keesing contributed the differences in skills of laborers to how many years of education received by different workers. See: Donald Keesing, Labor Skills and Comparative Advantages, American Economic Review 56, no. 2, May 1966.

21. Labor with Different Skills in US Exports and Imports Keesing found that in America there was a positive correlation between the ranking of the ratios of exports over the total output of an industry, that is (X / TP)i , and the above list of labor with different skills.In other words those industries in the US with more skilled labor would have exported a larger proportion of their output to abroad. Keesing also found that skilled labor (Category 1 till 7) accounted for 55% of the total labor requirement in the US exports of manufacturing goods which is higher than the same ratio for the US import substitutes. In the US imports unskilled labor is required in a relatively larger proportion. Thus it can be said that the US is exporting skilled labor-intensive goods while importing unskilled labor-intensive goods.

22. Keesing’s Conclusion • It must a common knowledge that a typical US laborer received more years of education on average than the foreigners and the US possessed substantially more scientists, engineers and the other sorts of skilled labor in the world. • Keesing argued that as a skilled labor abundant and unskilled labor scarce country the US trade pattern is consistent with the basic prediction of the H-O theory. There is no paradox.

23. The US Trade Policies • William Travis, suggested that the Leontief paradox might be duo largely to tariffs and other forms of protection. There is evidence that, in the United States and some other developed countries labor-intensive industries are relatively heavily protected. Such trade protection must influence trade patterns of those countries. • Robert E. Baldwin Baldwin tried to explain what he discovered by considering specific tariff policy and the other relevant trade policies taken by the United States. The US takes a lot of measures to protect its labor-intensive industries and at the same time encourages its capital-intensive goods exports by so many means. See: William. P. Travis, The Theory of Trade and Protection, Cambridge: Harvard University Press, 1964 and Robert E. Baldwin, Determinants of the Commodity Structure of U.S. Trade, American Economic Review 61, no. 1 March 1971.

24. Free trade, fare trade or no trade?!

25. Effect of Trade Policies • Such mixture of trade policies must have great impacts on the actual trade pattern of the US. • On one hand, protectionist policies, especially the high trade barriers, must inevitably hinder the foreign labor-intensive commodities from entering into the US domestic market. Consequently labor intensity of US imports would be relatively reduced. On the contrary, capital intensity of US imports would be relatively increased. • On the other hand a set of preferential policies for speeding up US exports would inexorably stimulate exports of US labor-intensive commodities thus relatively increase the proportion of labor-intensive commodities in US total exports and consequently the overall labor intensity of US exports might be relatively increased.

26. R & D Factor • Some economists analyzed proportion of R and D investment over the total sale and proportion of scientists and technicians over the total employees in 19 industries of the US. • Statistics showed that those industries with the relatively higher such proportions, such as transportation industry, chemical industry, machinery manufacturing industry, and instrument making industry, export more of their products overseas. Those four industries accounted for 39.1% of the total sale, 72% of the total exports and 89.4% of the total R and D investment of the US manufacturing industries. • Therefore, Gruber, Melta and Vernon concluded that those industries with more R and D investment thus an advanced technology are the major exporters of the US. See: W. Gruber, D. Melta, R. Vernon, The R and D Factor in International Trade and Investment of United States Industry，Journal of Political Economy, Vol. 75，February, 1967.

27. They insisted that the US had developed an advanced risk investment mechanism and constituted a comparatively greater capability of technologic innovation and creation it must enjoy a substantial comparative advantages over the other countries in the high-tech industries. • This country, the United States of America, produces and exports R and D factor-intensive goods based on its comparative advantages in high-tech industries derived from its relatively abundant R and D factor and meanwhile imports the sorts of products with relatively lower intensity of R and D factor from abroad. • The US trade structure is consistent with the basic principle of H-O Model and no paradox at all. • The argument of R and D factor presented, to some extent a reasonable explanation of Leontief paradox.

28. In real terms (constant or inflation-adjusted dollars), total R&D performance grew 40.5 percent between 1994 and 2000 at an average annual real growth rate of 5.8 percent over the period . Total 2003 R&D performance in the United States is projected to be $283.8 billion, up from an estimated $276.4 billion in 2002 and $274.2 billion in 2001. R&D performance as a proportion of GDP rose from 2.40 percent in 1994 to 2.69 percent in 2000 as growth in R&D outpaced the growth of the overall economy. The ratio of R&D to GDP peaked in 2001 at 2.72 percent as the rate of economic growth from the late 1990s slowed. In the subsequent years, total R&D grew at a slower pace than the overall economy, resulting in R&D to GDP ratios of 2.65 percent in 2002 and 2.61 percent in 2003.

30. Demand Bias • Stefan Valavanis-Vail might be a pioneer of this approach. In 1954 he suggested a hypothesis of consumption structures. • He argued that there would be possibility in the real world that a capital abundant country did not need to export capital-intensive good if her tastes are strongly biased toward capital-intensive goods. • Equivalently, a labor abundant country would import labor-intensive goods from abroad if residents of this country had a very strong bias toward consumption of labor-intensive goods. • Thus, Leontief Paradox can be explained if the US had a strong consumption bias toward the capital-intensive goods.   See: Stefan Valavanis—Vail, Leontief‘s Scarce Factor Paradox，Journal of Political Economy, Vol. 62，Dec. 1954. H. S. Houthakker, An International Comparision of Household Expenditure Patterns, Commemorating the Centenary of Engel’s Law，Econometrica, Vol. 25, Oct. 1957. Staffan Linder, An Essay on Trade and Transformation, Stockholm, Almquist and Wikell, 1961.

31. Statistics show that the industrial developed countries, typically the United States, indeed have a strong consumption preference to some high quality and thus expensive luxury goods (A relatively capital-intensive approach must be employed in production processes of those goods) since the overall income levels in those countries are much higher than the less-developed countries. • In order to meet a great requirement of their consumers many capital-intensive goods have been shipped from abroad. 

32. The opposite situation could be found in the less-develop countries with a very low income. • Consumption bias in those low-income countries would strongly toward inferior goods (They are basically labor intensive) and therefore they do import labor-intensive goods from abroad.

33. Theoretical Position of Leontief and His Paradox • In summary, Leontief’s research and his paradox not only triggered the extensive empirical tests of factor endowment theory but more importantly, induced more and more economists to do a lot of valuable research in depth in order to give the answer to such riddle. In this process they gave different explanations to the new discovery of Leontief. • They either explored the influences of production factors with different qualities or different essentialities on trade pattern of a country, or introduced some new factors into the theoretical framework, or analyzed the possible effects on trade of some distortions in the real economy. • Even though they took different methods in their analysis and they also focused on different points, they had a common ground. That is they all advocated the principle of factor endowment theory. They hoped lay a more scientific foundation for factor endowment theory by their research.

34. For this purpose, those economists inserted some new factors, which were abstracted by Heckscher and Ohlin when they established theoretical system of factor endowment theory, into theoretical framework of H-O Model. • More valuable is that all of those economists, happen to coincide, accentuated the effects of technical progress on trade pattern. • Their research thinking and the conclusions they had reached reflected the actual variations in development of international trade and the world economy. • Consequently what they had done in different research developed and refined trade theory particular factor endowment theory. • To this extent, we see without Leontief and his paradox it would not be expected that trade theory could have been developed so intensively.

35. Questions and problems • How to understand the significance of the empirical testing of trade theory? • Why people termed the discovery of Leontief’s study as a Paradox? What does the paradox mean? • How did Leontief himself present explanation of the paradox? • Try to illustrate the major explanations of Leontief Paradox. • Try to describe your own ideas concerning the origin and the reasonable explanation of the Paradox. • Try to illustrate the theoretical position of Leontief’s research and discovery in development of trade theory.