Tendency Toward Equalisation of Factor Prices of Heckscher-Ohlin Theorem

In Figure 5.1(a), it is assumed that country A’s currency is dollars and B’s currency is rupees. Under isolated position, one rupee can buy certain amount of B’s factor: The curve B is a straight line showing the prices of this amount of factors in country B, and all of them cost one rupee.

The curve A denotes the prices in dollars of the same amount of these very factors in country A, during isolation. The cheapest factor in A relatively is placed at the left, then the next cheapest, and so on.

As such curve A has an upward slope. Further, the relative position of curve A is determined by the exchange rate between dollar and rupee. When the exchange rate of dollar is say, 1 $ = 20 Rs. then factor price curve A in terms of rupees will be A.” This reveals that some factors in country A are relatively cheaper.

The factor combinations on the extreme left are very cheap in country A as compared to country B before trade, and when trade takes place these factors are obviously cheaper in A than in B. Thus, A will export goods incorporating larger proportions of these factors in their production function. Likewise, the factors on the extreme right are dearer in A relative to B. Therefore,

B will export goods using greater proportion of these factors in their production function. Where two curves A and B intersect, there are intermediate factors about which nothing can be stated a priori.

Figure 5.1 (b) represents the change in factor prices led by trade. It is easy to see that cross distance between A’ and B narrows down in effect. This means prices of the factors in A have tended relatively and absolutely to approach their prices in country B. Comparing the distance BA in Figure 5.1 (a) and Figure 5.1 (b), we find that the factors which were cheaper in A (toward extreme left of the curve) now fetch a higher price in A, a lower price in B, while the factors (towards extreme right) which were dearer in A have become cheaper and cheaper in B have become dearer.

Ohlin also stated that, though, in this example a large number of factors are considered, only two countries are assumed. But this reasoning can easily be extended to several countries as well.

On practical side, Ohlin contends that in the case of Australia, agricultural land would have been much cheaper than now, if no agricultural products were exported. Similarly, in America, forests would have been more costly than they are at present if there would have been no import of wood products from Canada and Scandinavia. He points out that the price of Australian land would have been raised and that of Europe lowered by the trade effect. Further, relative to the price of land, wages (labour price) have risen in Europe and declined in Australia due to an impact of international trade.

It must be noted that, under certain limited conditions only, this tendency towards factor price equalisation will be carried to the point where factor prices are fully equalised. In other words, the factor price equalisation theorem is based on the following assumptions:

(i) There are quantitative differences of factors in different regions, but no qualitative difference.

(ii) Production functions of different products are different, requiring different proportions of different factors in producing different goods.

(iii) There is perfect competition in the commodity markets as well as in the factor markets in all the regions.

(iv) There are no restrictions on trade, that is, free trade policy is followed by all the countries.

(v) The consumers’ preferences as well as the demand patterns and positions are unchanged.

(vi) There are stable economic and fiscal policies in the participating nations.

(vii) The transport cost element is ignored.

(viii) Technological progress in different regions are identical.

(ix) There are constant returns to scales in each region.

(x) There is perfect mobility of factors.

(xi) There is tendency towards complete specialisation.

Under these assumptions only the theorem holds that free trade between countries tends to reduce the original factor price inequality, and a state of complete specialisation in effect leads to a complete factor price equality.

However, complete factor price equality may be a theoretical possibility but it is hardly significant to be a practical phenomenon. Ohlin himself admits that a movement toward freer international trade might cause a partial international equalisation of factor prices. But a complete equalisation of factor prices will not occur for the following reasons:

1. There is the existence of transport cost in international trade.

2. There may be inter-country differences in the stages of technological advancement and managerial capacities. As such the production function for the same good might differ between regions, which will reduce the possibility of complete specialisation and in turn factor price equality.

3. There is unequal regional development in the economies of scale and the economies of agglomeration. This may tend to interrupt the tendency towards complete specialisation.

4. There are inter-country differences in tax structure, social objectives and economic policies.

5. There are inter-country differences in the buying habits of the people, consumers’ demands, and marketing costs.

6. In actual life, even within a region, mobility of factors of production is imperfect due to many impediments and obstructions. This obviously restricts the feasibility of complete specialisation and thereby, commodity as well as factor price equalisation.

7. Perfect competition also does not exist in reality. Thus, prices of the same factors may widely differ between industries on account of their differing demand and absorptions in these industries where there is maladjustment of resources caused by monopolistic elements. Moreover, monopolistic competition and discriminating monopolies tend to obstruct factor movements and the flow of trade which hinders the process of specialisation and factor-price equality.

8. Due to foreign exchange problem or other reasons sometimes when a country finds it impossible to meet its entire demand by improving a ‘dear factor bounded product’, it has to resort to domestic production as well. In this situation, there is no complete commodity specialisation, hence, there is no complete factor price equalisation.

9. Furthermore, factor units are not homogeneous even within a region. Thus, regions are not only quantitatively but also qualitatively differently endowed with different factors. This qualitative difference in factor units of different regions will account for differing factor prices even after the occurrence of trade.

10. According to Ohlin, if there is one country which has a world monopoly of a certain factor, trade will raise its price in this country due to extended derived demand, but it will not lower the price of this factor in other countries, as there is no supply of this factor elsewhere. So we cannot speak of factor-price equalisation theorem in such case.

11. Ohlin also mentions that if quite distinctive factors are in close competition when used in one industry to produce the same or a similar product while usually they are put to quite different
uses, then trade will fail to equalise factor prices. In actual practice many articles are produced by means of widely different technical processes giving differing ratios of returns and factor earnings.

12. Complete factor price equalisation requires free trade. In practice all countries resort to some protection at least and restrict their trade by tariffs, quotas, licences, exchange control and many other devices.

Ohlin thus, rightly concludes that the tendency of trade in equalising factor prices internationally has to be qualified in many respects. Especially, the difference in quality between productive factors in different nations, the wide differences in technical progress between countries, the economies of large-scale production causing decreasing costs, the differences in economic stability and tax structure, trade restrictions etc., and other impediments make it uncertain as to what extent trade can bring factor price equality in practice.

In short, when the costs of transport and other impediments to trade are taken into account, a complete factor price equalisation is obviously impossible. It follows that prices of productive factors vary from one region to another even after the establishment of free international trade because, in practice, it can lead only to a partial factor price equalisation.

In Kindleberger’s opinion, since trade tends to raise the price of the abundant factor weakening the price of the scarce factor and brings about factor-price equalisation, this repercussion of trade on factor prices is greatly important, politically as well as economically, especially where the trade is based on differences in factor endowments.

In conclusion, we may note that complete factor-price equalisation is an impracticable phenomenon. On the contrary, sometimes factor prices may even move apart as trade takes place.

This, however, does not imply that the factor-price equalisation theorem is totally useless. Though, it might not have any practical utility, it has theoretical significance in that it serves as a basis for explaining factor-price differentials actually observed in practice. It does provide a basis for the further analysis of forces affecting factor prices in international trade and for constructing some more realistic models of international economy.