Question

3. 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

The factor endowment theory holds that countries are 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 Hechsher-Olin Theory holds that a country will have a comparative advantage in the good that uses the factor with which it is heavily endowed. When calculating comparative advantage, it is essential to remember that it is the ratios of factors that matter; a country could be heavily endowed with both labor and capital, but it proportionally may have more of one than another than would another country. If a country has a comparative advantage in a good that uses the factor with which it is heavily endowed, it should focus it's production on that good. Because it is heavily endowed with that factor, it will be most efficient at producing the good that requires that factor for production. For example, a country with a high ration of capital to labor will be more efficient at producing computers than it would corn. If that country instead focused on producing corn, it would have to divert capital which is not meant for corn production into an area where it is inefficiently used.

In the Ricardian factor endowment theory of international trade all exchange is based on simple Ricardian comparative advantages. International trade takes place because different countries have different factor endowments of identical factors of production. This paper gives a popular introduction to the model and shows how it sheds new light on the age-old question of who gains form international trade. The paper also illustrates how the model can be used to analyze technology differences in international trade and the product cycle.

Factor endowments play important roles in international trade. Firstly, this paper describes the Heckscher-Ohlin theory in the general equilibrium (GE) framework. Secondly, this paper examines two crucial assumptions in the Heckscher-Ohlin (H-O) theory i.e. assumptions on production (technology) and consumption (tastes and preferences). Thirdly, this paper examines the comparative advantage of East Asian countries, which have large discrepancies in the factor endowments. By applying Revealed Symmetric Comparative (RSCA) index, this paper concludes that China, Indonesia and Thailand have comparative advantage in unskilled labor-intensive industries, meanwhile only Japan has comparative advantage in technology-intensive industries for the last two decades. The shifts in comparative advantage strongly support “flying geese” paradigm in East Asia.

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

A comparative advantage exists when the opportunity cost of specialization 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.

Factor price equalization is an economic theory, by Paul A. Samuelson (1948), which states that the prices of identical factors of production, such as the wage rate, or the rent of capital, will be equalized across countries as a result of international trade in commodities.

Free trade means that countries can import and export goods without any tariff barriers or other non-tariff barriers to trade. Essentially, free trade enables lower prices for consumers, increased exports, benefits from economies of scale and a greater choice of goods.

• The factor-price equalization theorem says that when the product prices are equalized between countries as they move to free trade in the H-O model, then the prices of the factors (capital and labor) will also be equalized between countries.
• Factor-price equalization arises largely because of the assumption that the two countries have the same technology in production.
• Factor-price equalization in the H-O model contrasts with the Ricardian model result in which countries could have different factor prices after opening to free trade.
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