Question

What is international Price Equalization, Answer with examples.

Answer 1

Solution =

The major theorem that arises out of the Heckscher-Ohlin (H-O) model is called the international price equalization theorem. Simply stated, the 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 theorem derives from the assumptions of the model, the most critical of which is the assumption that the two countries share the same production technology and that markets are perfectly competitive.

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.

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.