Page 52 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes Secondly, international trade would only lead to partial or incomplete specialization, but by no means
to complete specialization in production. This will, therefore, rule out the possibility of complete
factor price equalization. At best, we can expect partial equalization of factor prices.
This conclusion is based on the premise that there are diminishing returns to scale conditions in the
production of all goods in all countries.
Thirdly, the theorem is based on the assumption of perfect competition and diminishing returns to
scale in production. In the real world, however, there is imperfect or monopolistic competition on the
one hand, and on the other hand, there are increasing returns to scale in the production of some
goods. This would destroy the credibility of the factor price equalization theorem.
Fourthly, for complete factor price equalization to take place the number of factors should not exceed
the number of products. In a model of two countries, two factors and two goods, it is possible to show
factor price equalization. But, in a real world model of many countries, many factors and many
goods and services, it is not possible to argue for a complete equalization of factor prices.
Fifthly, the theorem would collapse once we show that the production functions are not identical in
all the countries taking part in international trade. The theorem will not hold good if the factor intensity
reversal takes place, because in that event a capital rich country and a labour rich country will export
the same good by using different techniques of production suited to their factor endowments. Factor
intensity reversals create obstacles to factor price equalization.
Finally, the theorem assumes that factor supplies remain fixed in every country. This is unrealistic,
because we do know that the supplies of labour and capital keep constantly changing over time,
almost in every country.
We can, therefore, conclude by saying that (a) factor price equalization is not possible in the real
world, because the reality of the world does not conform to the assumptions of the factor price
equalization model. This does not mean that the model or the theorem is invalid; it only means that
the assumptions of the model are unrealistic, which therefore lead the model to draw unrealistic
conclusions, (b) given the relative factor immobility between countries, international trade would
offer the best chance for equalization of factor prices and factor income between the countries of the
world. The factor price differentials would be even greater without international trade than it would
be with international trade.

The Stolper-Samuelson Theorem
According to their theorem, the opening of trade (i.e. free trade) will benefit the relatively abundant
factor and hurt the relatively scarce factor of production. Let us now demonstrate their theorem.
Stating their assumptions first.
1. The country, in question, is producing only two goods, say, steel and cloth, with the help of two
factors of production, viz, capital and labour.
2. Steel is capital intensive and cloth is labour intensive, and the production functions are
homogeneous of degree one.
3. The supplies of both factors are fixed.
Steel (K-Good)
D Labour B
P 1 T 1
S 1
R
T
Capital P 0 0 T 1 Capital
S
0
O S 1 P 1
S 0 P 0 T 0
A Labour C
Cloth (L-Good)
Figure 4.5 : Stolper-Samuelson Theorem.

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