Factor Price Equalization

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21 Aug, 2024

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The factor price equalization theory (FPE) of international trade states that the prices of elements (labor and capital) will be equalized across nations once output commodities are equalized as nations transition to free trade. This suggests that free trade equitably distributes worker earnings and capital rents worldwide.

It is the fourth main theorem that results from the Heckscher-Ohlin (H-O) Model. The H-O model's presumptions, which presume that technological advancements are the same globally, are used to derive the FPE theorem. Equalization of factor prices might result in changes in income distribution, specialization in production, and higher efficiency through abundant factors.

What Is Factor Price Equalization Theorem?

Factor price equalization theory suggests that, under certain conditions, factor prices will equalize across countries or regions when trade is unrestricted.
The theorem assumes perfect competition, factor mobility, and identical production technologies.
It affects income distribution, trade patterns, and efficiency gains. It suggests that factor prices becoming equalized can lead to changes in income distribution, specialization in production, and increased efficiency through the utilization of abundant factors.
However, the assumption of identical technologies and other factors can limit the equalization of factor prices.

Factor Price Equalization Theorem Explained

The factor price equalization theory of international trade is an economic theory that postulates that, in certain circumstances, the costs of production factors (labor and capital) will equalize across nations or regions when trade is allowed. Paul A. Samuelson proposed the idea of FPE in 1948. Paul A. Samuelson's factor-price equalization theorem extends the Heckscher-Ohlin model (Heckscher-Ohlin factor price equalization). The theorem assumes two types of goods and production factors: labor and capital.

The Samuelson factor price equalization theorem makes several other essential assumptions, such that each nation uses the technology to produce the same commodity pricing due to free trade in commodities. More importantly, these presumptions equalize factor prices between nations without requiring factor mobility, such as labor or capital flow migration. Therefore, before two countries economically integrate and effectively form one market, whatever factor receives the lowest price will become more expensive. The high price is in comparison to other economic variables, while those with the highest price would tend to become more affordable.

According to economic theory, trade in commodities and factor mobility are potent factors promoting factor price convergence across varied regions and nations. Goods markets are more tightly connected within a nation, and production factors are more movable there than between nations. As a result, FPE, to the degree that it exists anywhere, is more likely to occur within nations than worldwide.

Assumptions

In the Samuelson factor price equalization theorem context, certain assumptions are made to analyze the effects of factor price equalization. These assumptions include:

Perfect competition: Markets for factors of production, both the product markets and labor markets, operate under conditions of perfect competition, with no barriers to entry or exit for firms or workers.
Factor mobility: Factors of production (labor and capital) could freely move between countries or regions.
Identical production technologies: The production technologies used in both countries are the same, and they have the same production functions. This implies that both countries have access to the same knowledge and technology.

Additionally, the commodities have different factor intensities. It assumes no factor intensity reversal; one country is capital-abundant while the other is labor-abundant, with no complete specialization. Other assumptions include:

Furthermore, there is the absence of transport and tariff costs. These assumptions provide a framework to analyze the effects of factor price equalization on international trade and factor allocation.

Examples

Let us look into a few examples:

Example #1

Let's consider a hypothetical example to illustrate the reasoning behind factor price equalization. Dan is a soft skill trainer who lives in Country A, where there is a great demand for his abilities and where he may earn more money than in Country B, as the pay for soft skill trainers is considerably lower in Country B.

There is a lot of trade activity between both countries, and people have started to relocate. Dan might consider relocating to Country B to benefit from the increased pay in Country A. As trade between Country A and Country B expands, factors become more mobile. The same goes for other soft skill trainers in Country B who might consider relocating to Country A to take advantage of the greater pay there. The flow of skilled labor will continue until there is parity in the pay for soft-skill trainers in both nations. Due to the differences in the labor supply between Country A and Country B, the wages will eventually become equal.

Example #2

Factor price equalization can be seen in the European Union (EU) case. The EU allows for the free movement of labor, capital, and goods among member countries. This mobility of factors has equalized factor prices to some extent within the EU. Workers from lower-wage countries often migrate to higher-wage countries, leading to wage convergence over time.

Diagram

Let us look at the diagram of factor price equalization below to understand it:

The diagram illustrating factor price equalization shows two countries, Country I and Country II, each producing different commodities, 'm' and 'n,' respectively. They are depicted as operating on isoquants (equal product curves) 'mm' and 'nn'. The lines AB and CD represent the factor price lines for each country. Country I is shown as capital-abundant, leading to lower capital prices, while Country II is labor-abundant, resulting in lower labor prices.

Country I exports its capital-intensive 'm' commodity to Country II and imports the labor-intensive 'n' commodity from Country II. This trade process causes capital prices to rise in Country I and labor prices to increase in Country II. Additionally, the prices of the scarce factors in both countries decrease due to reduced domestic demand. This process continues until factor prices in both countries equalize, indicating that factors cost the same.

In the diagram, factor price lines AB and CD gradually adjust until they coincide at point PL, tangent to isoquants 'mm' and 'nn' at points T and S. This alignment signifies that factor prices in both countries are equal.

Criticisms

The factor price equalization theory, developed by Samuelson, has been criticized by economists for its highly restrictive and unrealistic assumptions. Several obstacles to complete factor price equalization have been identified. These include the presence of tariff and non-tariff barriers to trade and the existence of transport costs and specialization (as countries are of unequal size and complete specialization exists, at least in smaller countries).

Additionally, differences in production functions, imperfect competition in the product markets and factor markets, increasing returns to scale, changes in factor supplies, dynamic conditions, multi-country and multi-factor trade complexities, and the possibility of factor-intensity reversal.

In summary, the factor price equalization theory faces significant challenges due to various factors and conditions in real-life economic conditions that deviate from its assumptions. While it may not be completely invalid, its conclusions are limited in their applicability to real-world dynamics. Nevertheless, trade can play a role in reducing factor price differentials.

Frequently Asked Questions (FAQs)

1. Does factor price equalization occur in the real world?

Factor price equalization rarely occurs in the real world due to the complex interplay of various factors. Additionally, economic disparities, government policies, and market imperfections can further impede the full realization of factor price equalization. While some degree of convergence may occur, complete equalization remains a challenging goal in the global economic landscape.

2. What are the factor-price equalization theorem and Stolper-Samuelson theorem?

The Stolper-Samuelson theorem, also known as the Heckscher-Ohlin Factor Price Equalization theorem, asserts that, under specific circumstances, international trade causes factor prices in different nations to equalize. It implies that trading affects the pricing of factors, with abundant factors earning larger rewards and scarce elements earning lower rewards.

3. How do transportation costs affect the factor price equalization theorem?

The theory presumes no transportation costs, although imports and exports incur transportation costs. Complete factor price equalization is challenging to achieve since these expenses limit the mobility of goods and may undermine trade nations' competitive advantages.

4. How do transportation costs affect the factor price equalization theorem?