Question

Suppose the K/L ratio is higher in France than in Spain.  What would you expect to happen to wages in France as trade took place between the two countries?  Why?

Does price factor equalization effect this?

Answer 1

According to Hecksher-Ohlin theory, in a two country two product model with two factors labor and capital, after trade opens up, each country will produce that good which uses its abundant factor more intensively. Thus, a labor abundant country will export labor-intensive good and capital abundant country will export capital-intensive good.

In the given problem,    K/L ratio is higher in France. Thus, capital is relatively abundant in France and Spain has relatively more labor. As trade opens up, France will export capital-intensive good and Spain will export labor-intensive good.

Factor price equalisation theorem comes directly from the Hecksher-Ohlin theory. According to factor price equalisation theorem, as trade opens up and the price of the output goods are equalised, the prices of the factors will also get equalised.

In the given example, as trade opens up, France exports capital-intensive good. The demand for capital increases in France. Similarly, Spain exports labor-intensive goods. In Spain, the price of the labor-intensive good rises after opening up of trade as both the labor-intensive and capital-intensive goods are produced assuming diminishing returns to variable inputs. Thus, the demand for labor increases in Spain and the wages of labors in Spain rises. The demand for labor decreases in France, so, the wages decrease in France. Once the stage of specialisation is reached, that is, product prices are equal, the factor prices also become equal. Thus, price factor equalization affect the decrease in wages in France.