How we can use this model to determine the Direction of Trade

Eli Heckscher (1919) and Bertil Ohlin (1933) laid the groundwork for substantial 
developments in the theory of international trade. According to the theory, trade arises due to the differences in the relative prices of different goods in different countries. The difference in commodity price is due to the difference in factor prices (i.e. costs). Factor prices differ because endowments (i.e. capital and labour) differ in countries. Hence, trade occurs because different countries have different factor endowments.

The Heckscher Ohlin theorem states that countries which are rich in labour will export labour intensive goods and countries which are rich in capital will export capital intensive goods.

 In other words countries export what they can most easily and abundantly produce. The model emphasizes how countries with comparative advantages should export goods that require factors of production that they have in abundance, while importing goods that it cannot produce as efficiently.

Heckscher-Ohlin's theory explains the modern approach to international trade on the basis of following assumptions :-

1. Two countries
2. Each country has two factors (labor and capital)
3. Each country produces two commodities or goods (labor intensive and capital intensive)
4. Perfect competition
5. Factors are freely mobile within a country but immobile between countries
6. Trade is free 

Given these assumptions, the trade theory suggests that countries export goods that relatively use a greater proportion of its abundant and cheap factor while the same country imports goods whose production requires the intensive use of the nation's relatively scarce and expensive factor.

Understanding the concept of Factor Abundance:

A country where capital is relatively cheaper and labour is relatively costly is said to be capital rich country. Whereas a country where labour is relatively cheaper and capital is relatively costly is said to be labour rich country. 

USA is one such example of a capital rich nation and Bangladesh can be viewed as a country which is relatively abundant in labor. 

The HO model also specifies factor intensity of goods, in other words, it elaborates the use of different factor proportions for the production of different goods. Some goods require the intense use of labor for its production, example- ready-made garments. So the capital-labor ratio is low for production of garments. On the other hand, electronic products such as computers is a capital intensive good that requires less labor  in  its production.

The information we have so far is;

Bangladesh- relatively labor(L) abundant country

USA- relative capital (K) abundant country

Computer-  K-intensive good

Garments- L-intensive good

And; P- Price of the factor

Hence, we can write PK (U)  <  PK (BD)

                                       PL               PL

The above analysis highlights the fact that USA enjoys a lower price of capital and thus has a comparative advantage in the production of computers. On the other hand, Bangladesh can produce garments at a lower cost since labor is cheap and thus has a comparative advantage in the production of garments. The HO model concludes that a capital rich country (i.e USA) specializes in capital intensive goods (computers)  and exports them (to BD). While a Labor abundant country (BD) specializes in labor intensive goods (garments) and exports them (to USA).

Limitations of the HO model:

The Hecksher-Ohlin model has been criticised on the basis of the following assumptions:

1. Unrealistic Assumptions : The usual assumptions of two countries, two commodities, no         transport cost, no qualitative difference in factors of production, identical production             function, constant return to scale makes the theory unrealistic one.

2. Restrictive : The theory is not free from constrains. It includes only two                                       commodities, two countries and two factors. Thus it is a restrictive one. 

3. Static in Nature :The theory is based on a given state of economy and with a given                    production function and does not accept any change.

4. Wijnholds's Criticism : According to Wijnholds, it is not the factor prices that determine         the costs and commodity prices but it is commodity prices that determine the factor                 prices.

5. One-Sided Theory : According to Ohlin's theory, supply plays a significant role than                 demand in determining factor prices. But if demand forces are more significant, a capital       abundant country will export labor intensive good as the price of capital will be high due         to high demand for capital.

REFERENCE:

Investopedia Hecksher-Ohlin Model 2006, retrieved on 24 Oct 2014 from

http://www.investopedia.com/terms/h/heckscherohlin-model.asp

Heckscher Ohlin's (HO) Modern Theory of International Trade

Post: Gaurav Akrani Date: 3/21/2011, retrieved on 24 Oct 2014 from http://kalyan-city.blogspot.com/2011/03/heckscher-ohlin-ho-modern-theory-of.html
Hecksher-Ohlin Trade theory, retrieved on 24 Oct 2014 from
http://www.econ.rochester.edu/people/jones/Palgrave_Jones_on_Heckscher_Ohlin.pdf
Micheal P.Todaro and Stephen C.Smith, 2009. International trade theory and development strategy. Economic development, 10th edition. 2011-2012