State the Factor Price Equalization Theorem, and explain what it means. Use a diagram to demonstrate...

State the Factor Price Equalization Theorem, and explain what it means. Use a diagram to demonstrate where its main result comes from. What will happen to the wages and rents in the two countries in the long run?

Expert Solution

Factor price equalization theorem says that when the prices of the output goods are equalized between countries as they move to free trade, then the prices of the factors (capital and labor) will also be equalized between countries. This implies that free trade will equalize the wages of workers and the rents earned on capital throughout the world

The factor price equalisation theory picks up the argument that the labour-abundant country specialises in the export of the labour-intensive commodity because labour is a relatively cheaper factor compared with capital. On the other hand, the capital-abundant country specialises in the export of capital-intensive commodity on account of capital being a relatively cheaper factor there. The pressure of international demand renders the abundant factor scarce and its price starts rising.

the relative price of labor is measured along the horizontal axis, and the relative price of commodity X is measured along the vertical axis. Since each nation operates under perfect competition and uses the same technology, there is a one-to-one relationship between relative price of labor and relative price of commodity X.

Before trade, nation 1 is at point A while nation 2 is at point C. With lower relative price of labor in nation 1 than in nation 2 in absence of trade, relative price of commodity X is lower in nation 1 than in nation 2 so that nation 1 has comparative advantage in commodity X.

As Nation 1 (the relatively labor abundant nation) specializes in the production of commodity X (the labor intensive commodity) and reduces the production of commodity Y, the demand for labor increases relative to the demand for capital and relative price of labor rises in Nation 1. This causes relative price of commodity X to rise in Nation 1. On the other hand, as Nation 2 (the capital abundant nation) specializes in the production of commodity Y (the capital intensive commodity), its relative demand for capital increases and realtive price of capital rises.

This causes relative price of commodity Y to rise or relative price of commodity X to fall.

This process will contine until relative price of labor & relative price of commodity X is identical (point B) in both nations assuming both nations operate under perfect competition and use the same technology.

Equalization of absolute factor prices means that free international trade also equalizes the real wages for the same type of labor in the two nations and the real rate of interest for the same type of capital in the two nations. However, given that trade equalizes relative factor prices, that perfect competition exists in all commodity and factor markets, and that both nations use the same technology and face constant returns to scale in the production of both commodities, it follows that trade also equalizes the absolute returns to homogeneous factor

Rahul Sunny answered 2 years ago

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