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Equalization of Factor Prices in International Trade

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Let us make in-depth study of the equalization of factor prices in international trade.

It is important to note that trade tends to equalize not only commodity prices but also factor prices.

The exports of a product using the abundant factor by a country will cause the demand for that factor to increase and thereby make it relatively less abundant and raise its price.

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On the other hand, the imports of a product embodying large amounts of relatively scarce factor would make it less scarce and tend to lower its price. Thus changes in factor prices following the trade of com­modities between the two countries result in equalization of factor prices in them.

Let us take an example. As noted above, in U.S.A. capital is relatively abundant and cheap whereas labour is relatively scarce and expensive. On the country, in India labour is relatively abundant and cheap whereas capital is scarce and expensive.

With these factor endowments it will pay India to export labour-intensive commodity cloth which it can produce at a cheaper price and in exchange to import capital-intensive commodity machines from U.S.A. which it can produce them at a lower price. As a result of this trade, the demand for labour in India would increase and its price would tend to increase.

Now, with the imports of labour-intensive commodity cloth by U.S.A. and concentrating its more resources on production of capital-intensive machines, the demand for labour in U.S.A. would decrease and its price would tend to fall. Thus, other things remaining the same, the price of labour in India and U.S.A. would tend to become equal after opening up of trade between the two countries.

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The same applies to the price of capital. To sum up, according to Heckscher-Ohlin theory, free trading of commodities between the two countries results in equalization of factor prices. If factors were mobile between countries, then the free movement of factors from one country to another would have equalized their prices. But in actual practice factors lack interregional and international mobility. Therefore, in ab­sence of trade of commodities, factor prices would not tend to the become equal in the different countries.

Thus Ohlin argues that what would have been accomplished through free movement of factors between countries is indirectly accomplished through movement of commodities embody­ing different factor-proportions. Indeed, according to Ohlin, international trade in commodities serves as a substitute for international mobility of factors.

It is worthwhile to note that trade would achieve complete factor price equalization only when some conditions and assumptions are fulfilled. It is also realised that these conditions and assump­tions are quite restrictive so that in actual practice differences in factor-prices are not completely eliminated.

The conditions and assumptions underlying the factor-price equalization theorem are:

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1. Tastes, that is, demand pattern for commodities, are the same

2. It is the supply conditions of the factors which are different in different countries and no qualitative differences prevail in them. This implies that the level of technological progress is the same in the different countries.

3. Production function of each commodity is the same in the different countries and is of a simple character, that is, it is either capital-intensive, or labour-intensive. In other words, production functions of commodities provide a limited degree of factor substitution.

4. There are no restrictions on trade in the form of tariffs and quotas in the trading countries.

5. There are no transport costs.

6. There exists perfect competition in the commodity market as well as in factor markets in each region or country.

Since in the real world, above conditions are not fulfilled, complete factor price equalization does not take place. However, this does not invalidate the factor price equalization theorem. Indeed, every theory is based upon some assumptions. What this theory asserts is that, given the above conditions, factor prices would become equal. To the extent these conditions do not exist, factor prices will remain unequal even after trade takes place between the countries.

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