The Relative Factor Price Equalization
The relative factor price equalization theorem states that the relative prices for two identical factors (inputs) of production in the same market will eventually equal each other because of competition. The price for each factor need not become equal, but the relative factors will. Whichever factor receives the lowest price before two countries integrate into a single market will therefore tend to become more expensive relative to other factor of production in the economy. Factors which have the highest prices will tend to become cheaper.
Under the Heckscher-Ohlin model, the production of the good that uses the country s abundant resource would increase, increasing the demand for such resource while the production of the good that uses the country s scarce resource would decrease, releasing both scarce and abundant resources (Markusen et al, 1994). As the production of the using the abundant resource intensively increases, demand for that resource will increase. Now, the demand for the scarce resource will increase by a smaller amount. As the production of the good which uses the scarce resource intensively decreases, both abundant and scarce resources will be released, but relatively more of the scarce resource will be released than the abundant resource.
In the first diagram, labor is the abundant resource. Increasing the production of the good which uses labor will increase the demand for labor. At the same time, this will decrease the production of good which uses capital. However, the demand for capital will increase by a smaller amount because of the expanded production of labor-intensive goods (capital is also used in the production of these goods).
The Stolper-Samuelson Theorem states that a change in the price of a traded good results in a proportional change in the price of the factor used intensively in the production of that good (Helpman Krugman, 1989). As a result, wages proportionally increase more than the increase in the relative price of the labor-intensive good. Under the Heckscher-Ohlin model, the price of the abundant factor will increase proportionally more than the increase in the price of the good which uses the abundant factor intensively. This results in an increase in the real wages of the labor-abundant country. The price of the scarce resource will decrease proportionally more than the decrease in the relative price of the good that uses the scarce resource intensively. This results in a decrease in the real price of the scarce resource and the rental price of capital in the capital-poor country.
It is possible for equalization not to occur even if the basic assumptions of the Heckscher-Ohlin model hold (due perhaps to unwarranted transportation costs, barriers to trade, and the existence of goods which are rarely traded). However, the relative factor price equalization theorem suggests an important policy alternative allow free trade in outputs, specialize in labor-intensive production, and export labor indirectly in the form of labor-intensive goods (Helpman Krugman, 1989).
How does relative factor price equalization occur Initially, relative factor prices differ across countries (diagram 3). Note that country A is labor abundant (LKb LKa) while country B is capital-abundant (KLa KLb). Note that the production isoquants of country A is oriented towards labor, while country B is towards capital.
The relative price of capital-intensive good in country A is less than the capital-intensive good in country B (PxPy)A (PxPy)B. Hence, the real wage in A is less than the real wage in B. By transitivity, rental rate in A is greater than the rental rate in B.
After trade, the demand for labor in A will increase as production is oriented towards X, away from Y. The demand for capital in B will increase as production is oriented towards Y, away from X. In country A, real wage will increase while the rental rate will decrease. In country B, real wage will decrease while the rental rate will increase. As a result, (PxPy)A (PxPy)B (terms of trade). The relative factor prices for each good tend to equalize (long-run). However, this equalization process is only possible under competition. Competition promotes factor mobility across countries and increased specialization.
How is factor price equalization related to income distribution An obvious solution would seem to be for the government to use taxes and subsidies to facilitate compensation. Note that factor price equalization always results to gains and losses in trade. For example the government could place taxes on those who would gain from free trade (or trade liberalization) and provide subsidies to those who would lose. However, if this were implemented in the context of many trade models, then the taxes and subsidies would change the production and consumption choices made in the economy and would act to reduce and eliminate the efficiency gains from free trade (Pareto optimality). The government taxes and subsidies, in this case, represent a policy-imposed distortion which, by itself, reduces aggregate economic efficiency. If the compensation package reduces efficiency more than the movement to free trade enhances efficiency then it is possible for the nation to be worse off in free trade when combined with a taxsubsidy redistribution scheme. The relative changes in taxsubsidy levels affect consumption and investment levels. Labor-abundant countries experience an increase in capital allocation while capital-abundant countries experience a surge in labor supply. Eventually, equilibrium is reached, and gains (or losses) are made. How is this related to efficiency Efficiency is attained because overall supply of labor is matched with overall supply of capital. In a sense, market players (countries) seek to fully utilize their abundant resource in order to attain a higher degree of efficiency. In the long-run, factor price equalization is beneficial for both capital-abundant and labor abundant countries (Bhagwati et al, 1998).
The simple way to eliminate this problem, conceptually, is to suggest that the redistribution take place as a lump-sum redistribution. Lump-sum redistribution is one that takes place after the free trade equilibrium is reached (after factor price equalization), in short, after all production and consumption decisions are made, but before the actual consumption takes place. Lump-sum redistributions are analogous to Robin Hood stealing from the rich and giving to the poor. As long as this redistribution takes place after the consumption choices have been made and without anyone expecting a redistribution to occur, then the aggregate efficiency improvements from free trade are still realized. Of course, although lump-sum redistributions are a clever conceptual or theoretical way to restore efficiency. Therefore, the gains from trade (as a result of relative factor price equalization) can be used to redistribute income.
The relative factor price equalization theorem has become the foundation of international trade. The reason is quite obvious. Relative factor price equalization is a precondition to global redistribution of wealth indeed, a drive towards economic development.