In order to understand factor price equalization theory, it is required to comprehend Heskscher-Ohlin theory. In this sense, first, Heskscher-Ohlin theory will be examined briefly.
When there is only one factor of production which is labor, comparative advantage can occur by differences in labor productivity internationally (Ricardian Model). However, while trade can be partially clarified by differences in labor productivity, trade also projects differences in the resources of countries. For example; Canada exports forest goods to USA because Canada has more forest than USA relatively. In a realistic view, trade has to consider other factors like land, capital etc. not only labor.
It is needed to examine a model which uses resource differences of countries as only source of trade in order to understand the place of resource differences of countries in trade. In this model, comparative advantage is occurred by the relative abundance of factors between nations and technology of production which affects relative intensity. Heskscher-Ohlin theory is a theory which emphasized relative abundance of factors and relative intensity. It is necessary to examine a country before trade and after trade to understand Heskscher-Ohlin theory.
2. A Model of Two-Factor Economy
In this model, it is assumed that economy has an ability to produce two products; cloth and food, and each of the products requires the use of two factors; land (in acres) and labor (in hours).
The focal point of the theory is how much labor or land is used to produce given amount of cloth or food, rather than how much amount of labor and food are needed to produce that amount of cloth or food. This situation creates some choices for the usage of inputs. Input choices depend on factor prices (w/r). For example; if price of one input is lower and other one is high, producers will use input which has lower price.
3. Goods Prices and Factor Prices
Suppose that the economy produces both goods; cloth and food, and also, assume that competition between producers will cause that price of goods are equal to cost of production. The cost of production is based on factor prices. The important point to determine prices is how much a factor is used in production of a good. For example; while a country is producing cloth, if they use low land, then increase in land prices doesn’t affect cloth prices significantly. But if they use more labor, then increase in labor prices will cause to rise in price of cloth. The relationship between factor price (w/r) and relative price of cloth (PC/PF) is shown in figure 2 by SS curve.
Figure 1 and figure 2 can be represented with one graph like in figure 3.
There is an important result can be obtained from integrated graph in figure 3. This result is that increment in relative prices will increase the purchasing power of employees and will decline purchasing power of landowners by enhancing real wages and reducing real rents.
4. Resources and Output
The allocation of resources can be determined by using “box diagram”. In the box diagram represented in figure 4, horizontal axis represents labor supply, and vertical axis shows land supply, and QC line indicates employment of resources in cloth industry, and QF line exhibits employment of resources in food industry. The allocation of resources realize on point which QC and QF lines intersect.
When both supply of labor and prices of goods are kept fixed, if supply of land increases in the economy, this situation will cause to that production of labor intensive goods will decrease, and to that usage of land and labor in land intensive goods will increase as it is shown in figure 5.
Also, increment in supply of land will induce to rise in production possibility frontier (PPF). Biased expansion of production possibility which can be defined as occurred situation when PPF shifts more in one direction than in other direction is lived. It is shown in figure 6.
5. Impacts of International Trade Among Two-Factor Economies
Now, two economies which are called as home and foreign, and are trading with each other will be examined. Here, economies have same relative demand for both goods with identical relative price. Also these countries have same technology. There is only one difference between home and foreign, and this difference is in resources. Home has more labor than foreign, and foreign has more land than home.
6. Relative Prices and the Pattern of Trade
It was stated that labor abundant country is home, and land abundant country is foreign. It should not be forgotten that “abundance” is defined as relatively.
Home will produce more cloth because cloth is labor intensive product, and home has more labor which means that home is labor abundant. So, relative supply curve of home for cloth will be at the right of relative supply curve for foreign for cloth on graph. It is known that trade brings a convergence of relative prices. This means that in home, relative price of cloth will go up and relative price of foreign for cloth will fall. Because of this, new relative price of world will be between two of them. The increase in relative price of home will cause to soar production of cloth, and dwindle in relative consumption. This event will induce that home will become exporter of cloth and home will become importing country for food. Reverse of this situation occur for foreign.
7. Trade and Income Distribution
International trade possesses strong impact on distribution of income. How? It is known that trade create a convergence of relative prices. Purchasing power of employees increases by increment in the price of cloth for both goods, while it is decreasing purchasing power of landowners for both goods. It can be said that, in home, people who have income which is derived from labor will gain when relative price of cloth goes up. However, people who obtain their incomes from land will make worse off. Shortly, in a country, owners of abundant factors get advantage from trade, while owners of scarce factors are making worse off.
8. Factor Price Equalization
When there is no trade, in home, labor suppliers will gain less than in foreign, and land owners will earn more. Home which is labor abundant would get a less relative price of cloth than foreign which is land abundant, and these differences in relative prices of product means distinctness in the relative price of factors.
When countries begin to trade, convergence in relative prices of products will be seen. Because of this convergence, relative price of labor and land will converge too. So, tendency towards equalization of factors prices will happen. How far the tendency goes on?
The answer is that this tendency continues all the way in this model. International trade causes to exact equalization of factor prices. Even if ratio of labor to land is higher in home than in foreign, rent on land and wage rate will be equal in two countries, if they trade once. This is shown in figure 2 before. When countries have identical relative prices of food and cloth, this means that same factor prices exist for both countries.
To comprehend how the equalization happens, It should be noticed that something which is not only crude exchanging of products is occurring when both counties trade. Both of countries are trading their factors of production one to each other indirectly. Home allows foreign to use some of abundant labor by selling labor intensive goods, not by selling labor directly. So, home exports its labor by selling labor intensive products. In contrast, foreign is selling its land in an indirect way because foreign exports land intensive products. When it is examined from this side, it is too normal that international trade create equalization of factors prices.
Even if this side of trade is attractive and simple, there is a big problem which is that prices of factors are not equilibrated in the real world. Table 1 can be shown as an example. In Table 1, huge differences in wage rates among nations are seen. Some of these differences can be explained by distinctness in the quality of labor, but it cannot be clarified by only on this bases.
To comprehend why this model does not provide certain estimation, its assumptions have to be checked. There are three assumptions which are important to estimate equalization of factor prices, and are not true in the real world. These assumptions were; 1) two of the countries are producing both of products, 2) these two countries have same technology, and 3) trade really equilibrates the prices of products in both of countries.
First assumption which is that two of countries are producing both of products is to create rates of wages and rents from cloth and food prices. A country which has too high ratio of labor to land can produce just cloth, or other country which has too high ratio of land to labor can produce just food. This means that equalization of factor prices happens only if countries involved are enough alike in their relative factor endowments. So, there is no need to equalize factor prices between countries.
The idea that international trade equalizes prices of factors cannot be realized if countries do not have same technologies. For example; a country which has superior technology can enjoy with both higher wage and rental ratios more than other country which has inferior technology.
As a final, complete equalization of factor prices is based on complete convergence in prices of products. But prices of products cannot be equalized fully by international trade in the real world. This deficiency of convergence is occurred because of natural barriers such as transportation costs and of trade barriers such as import quotas, tariffs etc.