Factor Price Equilibrium

1. Factor Price Equilibrium We have seen what happens to trade flows under HO model. What happens to factor prices?

2. H-O Theorem “A country will export the good which intensively uses its relatively abundant factor” Implications: International trade pattern of H-O type strongest between countries with widely differing endowments Useful to explain trade pattern between developed and developing countries H-O trade is INTER-INDUSTRY TRADE, i.e. trade between different industries

3. Factor-Price Equalization Theorem (FPE) FPE: “In equilibrium, with both countries facing the same relative product prices, with both having the same technology, and with constant returns to scale, relative and absolute factor prices will be equalized”

4. Derived demand for factors Demand for final commodities Supply of factors Technology Tastes Distribution of ownership of factors of production GE framework of HO model in OPEN economy where prices are exogenous Commodity prices Factor prices

5. FPE After trade: In US: price of cars rises price of shoes falls Signal to producer: produce more cars In SA: price of shoes rises price of cars falls Signal to producer: produce more shoes

6. FPE PPF in US: to produce more cars resources must shift from shoes to cars (perfectly mobile) BUT: Shoe production is labour intensive and car production is capital intensive At pre-trade wage/rental ratio in US: Excess demand for capital Excess Supply of labour

7. FPE r SK w SL Factor-Price adjustments in US: Excess demand for K Excess supply of L r1 w0 r0 w1 DK2 DL1 DK1 DL2 K L

8. FPE PPF in SA: to produce more shoes resources must shift from cars to shoes (perfectly mobile) BUT: Car production is capital intensive and shoe production is labour intensive At pre-trade wage/rental ratio in SA: Excess demand for labour Excess Supply of capital

9. FPE r SK w SL Factor-Price adjustments in SA: Excess supply of K Excess demand for L r0 w1 r1 w0 DK1 DL2 DK2 DL1 K L

10. Summary of FPE Schematic outline of Factor Price Equalization Theorem

11. This explains why relative factor prices converge • BUT what about absolute factor price convergence?

12. Absolute factor price convergence • Differences in relative output prices cause trade • As long as relative factor prices differ, then relative output prices will differ • And trade will continue until relative factor prices are equal • Under free trade, Output prices are equal • Under zero profit assumption, costs are equal • Under assumption of same technology, this implies that factor prices are equal • Question: What if wages were lower in SA under free trade?

13. P*us P*SA Absolute FPE Before trade:

14. FPE After trade: Relative prices converge: US prices of shoes fall with imports from SA SA prices of cars fall with imports from US P*us P*World P*SA

15. Major implication • Under Free trade, there is no longer an incentive to migrate in response to wage differences • Trade in goods is a substitute for trade in factors • Labour in labour-abundant economies is expected to benefit from liberalisation • Some factors gain, other factors lose

16. Does Empirical evidence support FPE

17. FPE With FPE, commodity trade removes incentives for factors to migrate But: Empirical evidence does not support FP EQUALIZATION Why? H-O ignores : Different technologies Differences among factors Imperfect competition Transport costs, tariffs, domestic distortions Increasing returns to scale Nevertheless: it gives some explanation for FP CONVERGENCE