Question

What is Factor- Endowment Theory of Trade? How is it related with the Ricardian Theory of Trade (Comparative Advantage Theory of Trade)? Explain how free trade among two nations does not only lead to product price equalization but also to the factor price equalization among the trading nations.

Answer 1

Factor Endowment are the land, labour, capital and resources that a country has access to, which will give it an economic compartive advantage over countries. The Factor Endowment Theory ( also known as Heckscher-Ohlin Theory, and the Modern Theory of International Trade) is a "modern" extension of the classic approach and attempts to explain the pattern of comparative advantage. The Factor Endowment Theory holds that countries likely to be abundant in different types of resources. In economic reasoning, the simplest case for this distribution is the idea that countries will have different ratios of capital to labor. Factor Endowment theory is used to determine comparative advantage. The Heckscher-Oglin theory (H-O theory)  holds that a country will have a comparative advantage in the good that uses the factor with which it is heavily endowed

A factor endowment represents how many resources a country has st uts disposal to be utilised for manufacturing-resources such as labor, land, money, and enterpreneurship. Countries with large or diverse factor endowments are typically more wealthy and able to produce more goods than countries with small factor endowments.Factor endowments also affect the opportunity cost of specialising in producing certain goods relative to others.

As a result of the differnces and variations in a country's endowments, factor endowment theory states in economic reasoning that these different breakdowns of capital to labour will determine a country's comparative advantage and what to manufacture or specialise an economy on.

A comparative advantage exists when the opportunity cost of specialisation is lower than that of other nations. The existence of a comparative advantage is, in turn, affected by things such as abundance, productivity, cost of labor, land, and capital. Other factors also might influence a country's comparative advantage in practical terms, such as a highly developed financial system or economies of scale.

Richardian Trade Theory takes cross-country technology differences as the basis of trade. By abstracting from the roles of factor endowment and factor intensity differences, which are the primary concerns of factor proportions theory, Richardian trade theory offers a simple and yet powerful framework within which to examine the effects of country sizes, of technology changes and transfers, and of income distributions. Moreover, its simple production structure makes it relatively easy to allow for many goods and many countries, and hence capable of generating valuable insights which are lost in the standard two-country, two-sector model of international trade.

The Factor-price equalisation theorem says that when the product prices are equalised between countries as they move to free trade in the H--O model, then prices of the factors (capital and labor) will also be equalised between countries. Factor price equalisation arises largely because of the assumption that the two countries have the same technology in production. The theorem dervies 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.

In a perfectly competitive market,the return of a factor of production depends on the value of its marginal productivity. The marginal productivity of a factor,like labor, in turn depends on the amount of labor being used as well as the amount of capital. As the amount of labor rises in an industry, labor's marginal productivity falls.As the amount of labor rises in industry,labor's marginal productivity rises. Finally, the value of productivity depends on the output price commanded by the good in the market.

In autarky, the two countries face differnt prices for the output gopds. The differnce in prices alone is sufficient to cause a deviation in wages and rents between countries because it affects the marginal productivity. However, in addition, in a variable proportions model the difference in wages and rents also affcets the capital-labor ratios in each industry, which in turn affects the marginal products. All of its means that for various reasons the wage and rental rates will differ between countries in autarky.

Once free trade is allowed in outputs, output prices will became equal in the two countries. Since the two countries share the same marginal productivity relationships, it follows that only one set of wage and rental rates can satisfy these relationships for a given set of output prices. Thus free trade will equalise goods prices and wage and rental prices.

Since the two countries face the same wage and rental rates, they will also produce each good using the same capital-labor ratio. However, because the countries continue to have different quantities of factor endowments, they will produce different quantities of the two goods.