International Trade

Factor Price Equalisation Theorem

In Hecksher-Ohlin's world, by trade, each countries' factor price (W/r) will be eventually the same. (Remember that in the H-O world, commodities can freely move while factors cannot. However, as a result of free trade of commodities, factor prices will be the same as well as commodity prices).

The relation between factor price (W/r) and factor intensity (K/L)

Assumptions we sustain:

  • As wage is relatively higher (W/r ), producers use more [1] K-intensive technology (k = K/L )
  • X is more labour intensive [2] (kX = KX/LX < kY = KY/LY)
  • Both countries have the same production technologies.
    		•
    If H country's total endowment ratio [3] is kH, the wage-rental ratio in H will range (W/r)U < (W/r) < (W/r)L

    The relation between factor price (W/r) and commodity price (PX / PY)

    As (W/r) increases, PX / PY increases, because X is more labour intensive.

    Before trade, [1] (PX / PY)F is greater than (PX / PY)H as H is labour abundant.

    Therefore, from the corresponding factor prices, (W/r)F > (W/r)H before trade.

    The Theorem

    Now combine the two graphs:

    By trade, the two countries' commodity prices will converge [1] to the one world price (PX / PY)W.

    Eventually, (PX / PY)F = (PX / PY)W = (PX / PY)H after trade.

    When (PX / PY) = (PX / PY)W, the only corresponding factor price [2] is (W/r)W.

    With (W/r)W, both H and F use kX and kY for the two sectors' production.

    More discussion - Factor Intensity Reversed

    We sustain the assumption that X is (always) more labour intensive. However, sometimes it is possible that two industries change the order of factor intensities. Suppose kY > kX when (W/r) is low, but kY < kX when (W/r) is high. Then the graph we saw before changes:



    The relation between (W/r) and (PX / PY) is not linear any more. When (W/r) is low, [1] as (W/r) increases, PX / PY increases because X is more labour intensive. Once (W/r) is higher [2] than (W/r)*, Y is more labour intensive. Therefore, as (W/r) increases, PY increases faster than PX, i.e. (PX / PY) decreases.

    In this case, even if there is one commodity price (PX / PYW in the world by trade, two factor prices [3] (W/r)' and (W/r)" can exist. We cannot guarantee that H and F have the same (W/r).


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