Page 51 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 4 : Modern Theories of International Trade : Theorem of Factor Price Equalization, H-O Theory, Kravis and...

Under autarky, country A produced at point M and country B at point R. The two countries’ factor Notes
price ratios were different, as measured by the slope of the line P P in the two countries. After the
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establishment of trade between the two countries, there is a shift in the equilibrium production points
: it shifts from point M to N in country A, and from point R to T in country B. P P factor price ratio line
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in country A (at point N) has the same slope as the P P line for country B (at point T), which shows
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that trade has led to equalization of factor prices in country A and B.
You may wish to compare the capital labour ratios in the two goods in the two countries, before and
after trade in order to be more clear about how the factor price equalization has resulted after trade.
In Figure 4.4, you will notice the following.
(a) In country A, at the pre-trade equilibrium production point M, the capital labour ratio is equal
to (the angle) MAE in X production, and it is equal to MFG in Y production. After trade, when
the country moves to production equilibrium point N, the capital labour ratio increases to (the
size of the angle) NAE in X production, and to NFG in Y production.
(b) In country B, at the pre-trade production point of R, the capital labour ratios in the production
of X and Y are measured by the angles RAB and RCD, respectively. The post-trade capital
labour ratios in X and Y production (at point T) have gone down to the size (of the angle) of
TAE and TCD, respectively.
(c) After trade, the capital-labour ratio in X production is NAE in country A and TAE in country B.
Since NAE = TAE, we can say that the factor-price ratio in X production is equalized between
the two countries. In the same way, the capital labour ratio in production, after trade, is TCD in
country B and NGF in country A. TCD is equal to NFG, and this shows equalization of factor
price ratio in Y production in the two countries.
Thus, we see that international trade brings about equalization of factor prices between countries
even in the absence of factor movements between the countries. It is in this sense that we argue that
international trade in goods and services, is a substitute for international movement of labour and
capital. In other words, international trade brings about equalization of both the product prices and
the factor prices. This completes our demonstration of the factor price equalization theorem.

Does factor-price equalization indeed take place in real life ?

Obstacles to Equalization of Factor Prices
Let us remind ourselves that factor price equalization would imply that after the establishment of
trade, the capital-labour ratio in the production of a good will be the same in both the countries. This
does not mean that the capital-labour ratio in the production of the two goods will also be equalized.
This question now is, how far the factor price equalization will conform to the actual reality.
The factor price equalization theorem is based on certain assumptions which are rather unwarranted
in real life. The following key points are worth taking note of, because they constitute obstacles to the
equalization of factor prices in the real world.
First, the theorem assumes complete free trade, i.e. the absence of tariff and non-tariff barriers to
trade. It also assumes that there are no transport costs in exporting and importing goods and services
between nations. In real world, we know that both exist. Their very existence, therefore, will prevent
factor price equalization that free trade could have otherwise brought about. For this reason, Ohlin
and others ruled out the possibility of complete equalization of factor prices. They believed that only
a partial equalization was possible. Indeed, they argued that there will at best be only a tendency
towards factor price equalization.
Complete equalization of factor prices could take place if, and only if, the factors of production were
themselves internationally perfectly mobile. In that sense, international trade in goods and services
is not a perfect substitute for international factor mobility. It is at best a close substitute.

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