What is the Leontief Paradox?
Leontief Paradox is an observation proposed by Wassily Leontief (1906–1999) that in spite of being the world's most capital-rich country, the US appeared on average to have exports that were slightly more labor-intensive than its imports. This was thought to be paradoxical because the Heckscher–Ohlin model of international trade led people to expect that US exports would be capital-intensive and its imports would be labor-intensive. There are two possible explanations for the paradox: first, the simple Heckscher–Ohlin model ignored the role of natural resources in affecting trade; and second, because of its large investments in human capital which gave it a highly skilled labor force, the effective US labor supply was much larger than the mere numbers of workers would suggest.
Leontief studied trade flows in the 1950s. Based on an input-output analysis of international trade he discovered that the U.S., a country with a great deal of capital, was importing capital-intensive commodities and exporting labor-intensive commodities. This is in contrast to prior theories of international trade, which predict that countries will specialize in and export goods that they have a comparative advantage in producing. This means that a capital-rich country, such as the U.S., would be expected to export capital-intensive goods and import labor-intensive goods from countries where labor is comparatively cheaper.
The Leontief Paradox, as it came to be known, led many economists to question the Heckscher-Ohlin Theorem, which states that countries produce and export what they can create most efficiently, depending on their factors of production. Moreover, they import goods that they cannot produce as efficiently. Several later economists proposed solutions to this apparent paradox, including the Linder Hypothesis and the Home Market Effect.
Notably, Leontief's Paradox does not account for human capital and the resulting difference between skilled and unskilled labor. Later researchers showed that U.S. exports were skilled-labor-intensive—or, in other words, human capital intensive relative to imports—resolving the Leontief Paradox in favor of the comparative advantage view.
Explaining Leontief Paradox
Leontief’s first study was based on computation from input-output tables constructed for the year 1947. He computed for various industries the direct and indirect capital and labor required to produce a given dollar value of output. He then calculated the effects on capital and labor use of a given reduction in both U.S. imports and exports so that the relative commodity composition of exports and imports remained the same.
The conclusion was that the given value of U.S. exports embodied less capital and more labor than would be required to expand domestic output to provide an equivalent amount of competitive imports. Expressed inversely, U.S. import replacement industries required more capital relative to labor than did U.S. export industries.
The Leontief conclusion that in the international division of labor, the U.S. specialized in labor-intensive rather than capital-intensive goods contradicted the widely accepted view derived from the H.O. theory. Since it was not doubted that the U.S. was relatively capital-abundant and relatively labor deficient, it would seem that, following the theory, exports should be capital-intensive and import labor-intensive. At first, there was no dispute over the H.O. proposition rather there was a dispute over the particular empirical contradiction presented by Leontief.
How are we to explain Leontief’s paradoxical results that the most capital-rich of all countries, the U.S. exports labor-intensive goods?
Leontief himself explained the contradiction by reference to measures of labor supply. A concept more relevant than treating labor as a homogeneous item internationally and measuring it in man years would be treating it as “efficiency units” on which the U.S. because it has more productive labor, has relatively more efficiency units than it has units of capital. Even working with the same amount of capital, the U.S. worker is more efficient than his foreign counterpart.
Leontief tried to explain his findings along two different lines. The one he gave priority ran in terms of differences in labor productivity. Leontief argued that American labor could not really be compared to labor in other countries because the productivity of an American worker is substantially higher (three times higher, suggested Leontief) than that of foreign workers.
This would be one way, according to Leontief, by which his findings could be reconciled with the 11.0 theorem. Most economists might acknowledge the superior quality of U.S. labor. Leontief quotes a study by LB. Kravis indicating that wages are higher in U.S. export industries than in import-competing industries as supporting evidence. This, however, conflicts with Leontief’s assumption of labor being a homogeneous factor of production, which would imply the same wage irrespective of occupation.
Another explanation for which Leontief has shown a certain understanding is connected with the two-factor framework and the broad use of the term capital. The only two factors explicitly taken into account are labor and capital.
But as Leontief notes: ‘Invisible in all these tables but ever present as a third factor or rather as a whole additional set of factors determining this country’s productive capacity and, in particular, its comparative advantage vis-a-vis the rest of the world, are natural resources, agricultural lands, forests rivers, and other rich mineral deposits.”
By taking into account this third factor an explanation for Leontief’s paradox can be found. It might be the case, for instance, that imports require more capital to labor than exports; it is still, however, possible that imports are intensive in the third factor, say land. If capital and the third factor (land) are substitutes but both are complementary with labor, it might be the case that import-competing goods are capital-intensive in the U.S. but land intensive abroad. By bringing a third factor, into account in this way, a possible explanation might be found.
In his analysis, Leontief took only one country into account only computed factor requirements for marginal changes in the production of American exports and import-competing goods. If factor reversals exist, it is fully possible for a capital-rich country to export its labor-intensive goods. The country will still use more capital-intensive methods in its export industries than any other country. Leontief never brought a second country into account. Had he done so and compared, for instance, the factor intensities in American export industries with those of Japan or Western Europe, he might well have found that American exports were capital-intensive compared to Japan or Western Europe exports. According to R.W. Jones, by invoking factor reversals we can thus explain Leontief’s puzzling results.
Another explanation for Leontief’s paradox has been given by Erik Hoff Meyer. He argues that if products relying to a large extent on natural resources are excluded from Leontief’s list of goods, the normally expected picture that the U.S. exports capital-intensive goods and imports labor-intensive goods will prevail.
W.P. Travis explains the Leontief paradox with the help of U.S. trade policy. He refers to the fact that U.S. trade is highly protected, a fact even more true when Leontief made his study than it is today. When Leontief made his study, most competitive imports considered crude oil, paper pulp, primary copper and lead, and metallic ores. These products were imported because the U.S. simply could not produce them. These products are more capital-intensive than any other products. According to Travis, U.S. protective trade policies alone, therefore, are sufficient to explain the Leontief paradox.
The discussion of the Leontief paradox has hardly been able to establish firm conclusions. It has provided a good deal of insight into the foreign trade position of the U.S., but it has hardly helped to establish or refute the H.O. theory of international trade. Static theories such as the factor price equalization theorem or the H.O. theory of comparative advantage should perhaps not primarily be viewed as geared toward empirical testing. They are the first and foremost means of studying the general equilibrium characteristics of open economies.
By studying the H.O. trade model, we have been able to get a good understanding of the meaning of general equilibrium. We have seen how the possibility of trade causes a change in commodity prices, giving rise to a change in factor prices, to a reallocation of factors of production, and a change in the production structure. All these variables are intimately linked together and it is not possible to change one of them without changing all the others.
Responses to the Leontief Paradox
For many economists, Leontief's paradox undermined the validity of the Heckscher–Ohlin theorem (H–O) theory, which predicted that trade patterns would be based on countries' comparative advantage in certain factors of production (such as capital and labor). Many economists have dismissed the H–O theory in favor of a more Ricardian model where technological differences determine a comparative advantage. These economists argue that the United States has an advantage in highly paid labor more so than capital. This can be seen as viewing "capital" more broadly, including human capital. Using this definition, the exports of the United States are very (human) capital-intensive, and not particularly intensive in (low-paying) labor.
Some explanations for the paradox dismiss the importance of comparative advantage as a determinant of trade. For instance, the Linder hypothesis states that demand plays a more important role than a comparative advantage as a determinant of trade—with the hypothesis that countries which share similar demands will be more likely to trade. For instance, both the United States and Germany are developed countries with significant demand for cars, so both have large automotive industries. Rather than one country dominating the industry with a comparative advantage, both countries trade different brands of cars between them. Similarly, new trade theory argues that comparative advantages can develop separately from factor endowment variation (e.g., in industrial increasing returns to scale).