Factor Endowment Theory

1
Factor Endowment Theory
(Heckscher-Ohlin Model)
2
Eli Filip Heckscher was a Swedish political
economist and economic historian. He studied at
university in Uppsala and Gothenburg, completing
his PhD in Uppsala in 1907. He was professor of
Political Economy and Statistics at the Stockholm
School of Economics from 1909 until 1929, when he
exchanged that chair for a research professorship
in economic history, finally retiring as emeritus
professor in 1945.
Eli Filip Heckscher (1879-1952)
Heckscher worked so hard in his life, till 1949,
he had published 1148 books and articles, among
which may be mentioned his study of Mercantilism,
translated into several languages.
In 1919, Heckscher published a research paper in
Swedish The Effect of Foreign Trade on the
Distribution of Income, in which he introduced
basic ideas about how to put trade on the basis
of a countrys factor endowment.
3
Bertile Ohlin was born into an upper-middle class
family in a village in the South of Sweden. He
got his B.A. from Lund University 1917, M.A. from
Harvard in 1923, and Ph.D from Stockholm
University in 1924. In 1925 Ohlin became a
professor at the University of Copenhagen. In
1930 he succeeded Eli Heckscher, his teacher, as
a professor of economics, at the Stockholm School
of Economics.
Bertil Ohlin (18991979)
Ohlins results were firstly published in his
doctoral dissertation in Swedish, Theory of Trade
in 1924, and afterward, far more fully in his
well known book in the Harvard Economic Series,
Interregional and International Trade in 1933.
Jointly won Nobel prize for economics with James
Edward Meade in 1977.
In this Ohlin built an economic theory of
international trade from earlier work by
Heckscher and his own doctoral thesis. It is now
known as the Heckscher-Ohlin Model, one of the
standard model economists use to debate trade
theory.
4

• For thirty years from 1919 till 1949 few scholars
  in the academic circle of international trade
  knew Eli Hechscher but most of them would be very
  much familiar with a famous name Bertil Ohlin.
  People once mentioned the theory of factor
  endowment as Ohlin model.
• Heckscher and his paper did not popularize at
  least for two reasons.
• At first the paper published in 1919 when the
  World War One just ended. The interests of the
  major powers in the world at that time were not
  on the issues of trade theory.
• Secondly, Heckscher had his academic activities
  mostly in Sweden and the paper was published in
  Swedish. But we know that Swedish is not as wide
  spread as English.
• Therefore, when Ohlin was well known and the
  theory was once termed as Ohlin model people
  seldom knew that it was Heckscher who was the
  originator of factor endowment theory.
• Heckschers article was first widely introduced
  to the academic circle in 1949 when American
  Economic Association included his famous paper in
  The Readings in the Theory of International Trade
  published in English with the contributive helps
  of Professor Svend Laursen and his wife who had
  undertaken the trouble of translating Swedish
  text of the paper into a proficient English.

5
Heckschers Illustration on Factor Endowment
Theory
6
Two Theoretical Assumptions of Heckscher

• Heckscher established his theory on two
  assumptions
• First, changes induced by foreign trade in the
  nature of the factors of production (dynamic
  changes) are completely disregarded. Thus the
  quantity of factors of production within a
  country is given
• Second, no attention is paid to the advantages
  one particular country may achieve by means of
  protection. That is to say he only discussed
  problem of international trade in the framework
  of free trade.

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If one initially employs all of the above
assumptions it follows from the nature of barter
that trade will create the maximum satisfaction
of wants or the maximum national income .
7
Source of Trade Benefit
Such a gain in total satisfaction arises whenever
the law of comparative costs operates
(???????????), i.e., whenever a want is more
easily satisfied in an indirect way, through the
production of another commodity which can be
exchanged for the commodity desired, than by
producing the latter directly.
Its so obvious that trade on the basis of
comparative cost advantages is the real source of
trade benefit. In order maximize a countrys
national income the country must be active in
trade rather to meet all of consumption wants of
its residents directly.
By trading with the other country it would be
cheaper for the home country to indirectly meet
the home demand for particular goods by importing
such goods from abroad, which could be paid with
its own exportable goods, rather than directly
meet the demand by producing import substitution
goods at home.
8
From Where Derives Comparative Advantages

• No different factor endowment no differences in
  relative price of production factors and no
  different comparative costs of products
  consequently no trade between different
  countries. It has been strongly suggested that
  different factor endowment between different
  countries must be the basic pre-requisite for
  trade between them. Besides that there must be
  different proportions of production factors in
  producing different goods.
• Heckscher mentioned the former as a necessary
  condition for a difference in comparative costs
  and consequently for international trade and he
  mentioned the latter as a further indispensable
  condition.
• From these two important conditions comparative
  advantages of particular country could be
  derived.

9
How did Heckscher illustrate his ideas?

• A difference in the relative scarcity of the
  factors of production between one country and
  another is thus a necessary condition for a
  difference in comparative costs and consequently
  for international trade.
• A further indispensable condition is that the
  proportions in which the factors of production
  are combined shall not be the same for one
  commodity as for another. In the absence of this
  second condition, the price of one commodity,
  compared with the price of another would remain
  the same in all countries regardless of
  differences in relative factor prices.

The prerequisites for initiating international
trade may thus be summarized as different
relative scarcity, i.e., different relative
prices of the factors of production in the
exchanging countries, as well as different
proportions between the factors of production in
different commodities.
10
Ohlins Illustration on Factor Endowment Theory
11
How does a country differentiate from another?

• There should be some kind of natural distinction
  between regions.
• The principal criterion used to differentiate one
  region from another is its endowment with factors
  of production.
• Hence, regions have different factor endowments,
  while the factors within a region are essentially
  similar.

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12
Varying Ability and Advantages of
Specialization

• What are the causes of division of labor in
  general?
• Why do individuals trade with each other, instead
  of each one producing his own requirements?
• Why does division of labor increase the total
  efficiency of production?
• The reasons may be grouped under two headings
  varying ability and advantages of
  specialization.

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13

• First of all, some individuals have greater
  ability for certain tasks than others. Varying
  natural aptitudes make one more fit to be an
  engineer, another better suited for the work of
  physician or a lawyer. Some people take greater
  interest in gardening than in other occupations,
  and hence probably make better gardeners than
  others. Examples could be multiplied.
• Second, even if all individuals had exactly the
  same natural abilities, it would be still be
  advantageous to have specialization in one or a
  small number of occupations. In this way much
  greater skill can be acquired than if everyone
  produced everything for himself. Furthermore, the
  workman who constantly attends to one task wastes
  no time changing over from one occupation to
  another.
• In short, there results an increase in skill and
  a saving of time when each individual is occupied
  in the production of a large number of one
  particular article instead of cooperating in the
  production of a small quantity of many different
  articles.

14
Sources of Comparative Advantages

• Turning from individuals to regions, one finds
  that the two regions might be quite differently
  endowed with facilities for the production of
  various articles. One reason is that they are
  differently supplied with productive factors. One
  region may have plenty of iron and coal but
  little land for wheat-growing, while another has
  plenty of wheat-growing land but a scanty supply
  of mineral resources clearly the former is
  better adapt to iron production and less well
  adapt to wheat-growing than the latter.

It is the proportion of the factors in a region
that determines its fitness for specific industry.
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15
Australia vs Great Britain
Australia has more agricultural land but less
labor, and capital, and mines than Great Britain
consequently, Australia is better adapted to the
production of goods that require great quantities
of agricultural land, whereas Great Britain has
an advantage in the production of goods requiring
considerable quantities of other factors.
16
Nature of a countrys factor endowment and its
Comparative Advantages

• The nature of a countrys factor endowment
  determines the method of production and then the
  relative price of production factors and
  consequently the relative costs of products and
  at last the comparative advantages of a
  particular country.

Relatively abundant factor ? extensive method of
employment ? relatively low price of this factor
? price of the goods requiring relatively large
proportions of the abundant factor would be
relatively low.
Relatively scarce factor ? intensive method of
employment ?relatively high price of this factor
? price of the goods requiring relatively large
proportions of the scarce factor would be
relatively high.
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17
In brief, each region is best equipped to
produce the goods that require large proportions
of the factors relatively abundant there it is
least fit to produce goods that require large
proportions of factors existing within its
borders in small quantities or not at all.
Clearly, this is the cause of interregional
trade, just as varying individual abilities is
cause of individual exchanges.
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18
Case of Australia
kangaroo
Australia has an abundant supply of agricultural
land but a scanty population. Land is cheap and
wages are high in comparison with most other
countries therefore, production of goods that
require vast areas of land but little labor is
cheap. This is the case with wool, for example.
Sheep-raising requires great areas of land but
little labor, and the shearing is a relatively
simple process hence, wool can be produced at a
lower cost than in countries where land is
expensive, even if wages in the other countries
are somewhat lower than in Australia. Similarly,
regions with an abundant supply of labor,
technically trained as well as unskilled, and of
capital will find it profitable to specialize in
manufactures, for labor is cheaper in such
regions than in Australia.
rangeland
19
Brief Summary
The conclusion follows that each region has an
advantage in production of commodities into which
enter considerable amounts of factors abundant
and cheap in that region

• Countries differ in their relative stocks of the
  different factors of production, these
  differential factor supplies influence the costs
  of producing particular goods. Differences in
  production costs lead to the comparative
  advantages of a country in international trade.
• A country with an abundant supply of capital and
  little labor, and therefore has a comparative
  advantage in and exports such capital-intensive
  goods.

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20
Prominent Characteristics of the Theory
Factor Endowment Theory of Heckscher and Ohlin
has a prominent characteristic which obviously
separate itself from trade theory so far of the
older generations of economists.
21
Clearing off the Labor Value Theory
Marxist political economy revealed the law of
capital accumulation and became an ideological
weapon of proletarian to fight against the
capitalist exploitation. It is necessary for the
so-called main trend economics to eliminate
influences of Marxism.
At first, the prominent characteristics of factor
endowment theory is to clear off the labor value
theory in analysis of the basis of trade. This
development represents the tendency of
vulgarization of economics in field of trade
theory. Ultimately to treat living labor as only
one of the factors just like capital and the
other materials is hard to be understood as a
progress. Where could we see the human rights?
22
Lay Comparative Advantages on a New Foundation
The arduous task of Heckscher and Ohlin is to
establish a real foundation for comparative
advantages. How did they do that?
They both agreed that mutually beneficiary trade
comes from the respective comparative advantages
of the trade partners. But they only took
comparative advantages as an existing
prerequisite. At the mention of sources of
comparative advantages they argued that they
could be only derived from the naturally
constituted factor endowment, the Gifts of the
Nature(?????).
23
Some Comments on Factor Endowment Theory

• Factor endowment theory breaks away from the
  classical labor value theory and tries to explain
  the reason of international trade in an entirely
  new way.
• Heckscher-Ohlin theory holds that comparative
  advantages enjoyed by different countries are the
  pre-requisite of trade. These comparative
  advantages, however, do not come from the
  relative differences in labor inputs of
  production as the classical economists described.
  
• It is the differences in a countrys production
  factor endowment that determines the production
  costs of different countries and thus their
  respective comparative advantages in
  international trade.

24

• That is to say it is factor endowment theory not
  labor value theory that functions as the
  foundation for international trade.
• This implies that comparative advantages and thus
  international trade do not related with labor at
  all. The very important comparative advantages
  are only the gifts of the nature.
• The basis of trade says good-bye to the labor
  value theory. This sort of theoretical
  development suits the need of bourgeois economics
  to negate the labor value theory since the theory
  functioned as the theoretical basis of Karl
  Marxs political economy theory, which concluded
  the ending of the capitalist system and springing
  up of the communist system.

25
Theoretical Position of H-O Theory

• Since Heckscher and Ohlin opened up a new path
  and established a so-called reasonable
  theoretical approach of explaining and analyzing
  issues of international trade their theory had
  been widely accepted in the academic circles in
  the western world and had taken the position of
  the orthodox or the main trend of trade
  theory.(?????????????)
• Therefore, factor endowment theory could be
  appropriately evaluated as a theoretic milestone
  in development of trade theory. Consequently, it
  has become the important theoretical origin of
  the so-called new trade theories developed in the
  past several decades.

26
The H-O-S Model

• The basic idea of factor endowment theory has
  been much refined and explored in the past
  several decades, in particular in a most famous
  series of papers by Paul Samuelson, W. Stolper,
  T. Rybczynski, and so on.
• Particularly, P. Samuelson published
  International Trade and the Equalization of
  Factor Prices (1948) and International
  Factor-Price Equalization Once Again(1949), the
  latter had been included in Readings in
  International Economics (1968) edited by American
  Economic Association.
• Samuelson systematically proved the basic
  principle of factor endowment theory by a
  rigorous mathematical approach and introduced his
  contributive ideas about the theory. Therefore,
  factor endowment theory is sometimes known as
  Heckscher-Ohlin-Samuelson Model or H-O-S Model

27
Several Theoretical Assumptions of the Theory

• The extended trade model
• Constant supply of productive factors
• Countries differ from each other only in factor
  endowment
• No technical progress and no changes of returns
  in scale

28
The extended trade model

• That is the so-called two country-two factor-two
  good model ( 222 model ). The model could be
  used to illustrate trade between the two
  countries when they produce two commodities by
  using two sorts of production factors.
• It holds that the two sorts of production factors
  and the two commodities are assumed to be
  homogeneous, respectively. That is to say no
  attention would be put on the influences of
  different qualities of the production factors and
  goods produced.
• The two trade partners would be assumed
  differently endowed with production factors while
  the two goods would be assumed with different
  factor intensities. In addition trade would be
  assumed to be executed under the barter trade
  system.
• If we define the two sorts of factors as capital
  and labor, in this model, it is assumed that one
  country endows relatively abundant labor but
  relatively scant capital while the other country
  has a relatively abundant stock of capital but
  labor is of relative scarcity. Further more, one
  commodity is assumed to be labor-intensive while
  the other commodity capital-intensive. At last,
  barter trade would be carried out. No money used
  in trade for simplifying the analysis.

29
Constant supply of production factors

• That implies the variations in a countrys
  natural endowment of production factors would be
  disregarded. In addition, factors of production
  are internationally completely immobile but
  intra-nationally freely mobile.
• With this assumption the unique factor price
  would be reached in one countrys domestic market
  for production factors. Because each countrys
  production factors and commodity market are
  assumed perfectly competitive the total amount of
  all sorts of factors of production could be fully
  employed.
• That means the two countries can both realize one
  of the macroeconomic goals, full employment of
  production factors.

30
Countries differ from each other only in factor
endowment

• The two countries are as the same as each other
  in almost every respect except their factor
  endowment. It follows that the same production
  techniques would be applied to produce the two
  commodities.
• Or equivalently speaking, the two countries have
  the same production functions of the two
  commodities.
• Furthermore, propensity to consume in one country
  is as the same as that in the other country.
• The same propensity to consume implies that
  consumption proportion of the two goods does not
  differ in the two countries when prices of the
  two commodities are given.

31
No technical progress and no changes of returns
in scale

• Constant Production techniques means the impact
  of technical progress on trade patterns will not
  be considered.
• Thus people can analyze respective comparative
  advantages of different countries exclusively
  derived from differences in factor endowments and
  trade patterns on the basis of such differences.
  
• The assumption of that returns in scale do not
  change in line with variations in production
  scale indicates that certain percentage of
  changes in input of production factors will lead
  to the same percentage of changes in the output
  produced.
• That means No diminishing returns of scale.

32
Brief summary of the assumptions

• From the above theoretical assumptions of the
  theory we can easily see that the essential
  difference between the theory and other trade
  theories is that it inserts a new element into
  its trade model.
• That is factor of production. The former 22
  model has been changed into the so-called 222
  model. By adding this element into trade model
  Heckscher and Ohlin successfully laid the basis
  of trade on different factor endowments of the
  countries participating international exchanges.
• In this 222 model, for instance the two
  countries, A and B, are producing and exchanging
  two goods, F and C, by using two sorts of
  production factors, L and K.
• In this model, if we say country A has a
  relatively abundant supply of labor and a
  relatively scant endowment of capital. It is
  equivalent to say that country B is relatively
  rich in capital endowment and it is relatively
  scantly supplied with labor.
• Similarly, in this model if Good F is
  labor-intensive that implies Good C is
  capital-intensive.

33
Two important theoretical problems

• To correctly understand the essentialities of
  factor endowment theory two important theoretical
  problems must be resolved in advance.
• Problem One How to define the factor abundance
  or scarcity of a country?(??????????????,?????????
  )
• Problem Two How to define factor intensities of
  different goods? (????????????????)

34
How to define the factor abundance or scarcity
of a country?

• Physical definition (????)
• A country is relatively labor abundant and
  capital scarce because , in this country than in
  its trade partner, more labor are allocated with
  certain amount of capital, or less capital are
  allocated with certain quantity of labor.
• Conversely, if relatively more capital could be
  allocated with certain quantity of labor, or less
  labor are allocated with certain amount of
  capital, in a country than in its trade partner,
  this country is a capital abundant and labor
  scarce country.
• It is very obvious that the so-called physical
  definition is actually a comparison between the
  capital/labor ratios, or the labor/capital ratios
  of the two countries.

35

• Lets use K and L stands respectively for capital
  and labor. In a two-country two-factor and
  two-good model,
• ?( K/L ) a lt ( K/L ) b ,
• or ( L/K ) a gt ( L/K ) b
• ?Country A is a labor abundant and a capital
  scarce country relative to Country B. Or
  equivalently, Country B is a capital abundant and
  a labor scarce country relative to Country A.

The K/L ratio is a very important criterion of
defining basic nature of a countrys factor
endowment.
36

• Economic definition(????)
• Sometimes, economic definition can also be
  termed as price definition(????).
• As we know factor endowment of a country
  determines the techniques to use the factors of
  production, extensive or intensive.
• Consequently, factor prices will be much
  different between the different countries with
  different factor endowment.
• In the trade model price of labor will be
  relatively low while price of capital relatively
  high in a labor abundant and capital scarce
  country.
• In the other country, the labor scarce and
  capital abundant one, price of labor will be
  relatively high while price of capital relatively
  low.

37

• If we use I and W for price of capital, interest,
  and price of labor, wage rate, respectively, we
  could have another definition of a countrys
  factor endowment. That is the ratio between
  prices of the two sorts of factors (for
  simplicity, we use the term factor price ratio,
  FPR).
• That implies the so-called economic definition is
  actually a comparison between different FPRs in
  different countries.
• In a two-country two-factor and two-good model,
• ?( W/I ) a lt ( W/I ) b , or ( I/W ) a gt (
  I/W ) b
• ?Country A is a labor abundant and a capital
  scarce country relative to Country B. Or
  equ8valently, Country B is a capital abundant and
  a labor scarce country relative to Country A.

38
Problem Two How to define factor intensities of
different goods?

• The basic assumption of homogeneous production
  techniques in the two countries holds that the
  two countries produce the two kinds of goods, F
  and C, in particular production functions.
• It is supposed that respective production
  functions of Good F and Good C are as the
  followings
• F f ( 8K, 4L ), while C f ( 6K, 2L )
• Or equivalently, the two countries are using the
  same production techniques to produce the two
  goods and factor proportions in production of
  Good F and Good C are as the followings
• 1F 8K 4L (8 units of K and 4 units of L
  should be employed to
• produce 1 unit of
  Good F)
• 1C 6K 2L (6 units of K and 2 units of L
  should be employed to
• produce 1 unit of
  Good C)

39

• From the above production functions it is obvious
  that for producing one unit of Good F more
  capital and more labor should be employed than to
  produce one unit of Good C.
• But we can say nothing about factor intensities
  of Good F and Good C only by comparing the
  absolute quantities of K and L in producing
  certain amount of them. Otherwise, we could fall
  into a theoretical paradox.
• However, if we compare the relative factor
  inputs, in other words factor proportions of
  production functions, that is how to combine the
  two factors in production process we can find out
  that proportions of factor employment or relative
  ratio of factor input in producing Good F clearly
  differs from that in Good C.

40

• In producing 1 unit of Good F, 2K are equipped
  for 1L, in other words 1L is equipped with 2K. In
  production process of Good C this number is 3.
  Three units of capital must be allocated for 1
  unit of labor. That means more K should be
  allocated for certain labor input in producing C
  than F.
• Equivalently, in producing 1F, 1/2 L used for 1K,
  in other words for using 1K a half L must be
  employed with the given production technique.
  While in producing 1C, for 1K, 1/3 labor is
  enough.
• Consequently, we say Good F is a L-intensive good
  relative to Good C while Good C is a K-intensive
  good relative to Good F.
• Therefore, comparison of relative ratios of
  factor input in producing different goods serves
  as the only definition of factor intensity of
  particular commodity.

?

Good F is relatively labor intensive Good C is
relatively Capital intensive.
?
41
Theorems of the Factor Endowment Theory
Heckscher-Ohlin Theorem
Basic Theorems
Factor Price Equalization Theorem
Factor Endowment Theory
Stolper-Samuelson Theorem
Extensive Theorems
Rybczynski Theorem
The factor endowment theory has four theorems.
They are two basic theorems and the other two
extensive theorems.
42
Heckscher-Ohlin Theorem(????????)

• Heckscher-Ohlin Theorem can be summarized as the
  followings
• Comparative advantages of different countries
  serve as the basis of trade. Such comparative
  advantages come from the differences in their
  factor endowments. Therefore, different factor
  endowments among countries are the real cause of
  international trade.
• Consequently, a country has its comparative
  advantage in production of that good in which its
  relatively abundant factor is relatively
  intensively used.
• That is to say a country with a relatively
  abundant labor endowment and a relatively scarce
  capital endowment, thus its W/I ratios is
  relatively low, has comparative advantages in
  production of L-intensive good.
• Meanwhile, a country with a relatively abundant
  capital endowment and a relatively scarce labor,
  thus its W/I ratios is relatively high, has its
  comparative advantages in production of
  K-intensive good.

43

• The respective comparative advantages determine
  production and trade structures of the two
  countries.
• In accordance with their respective comparative
  advantages the former should concentrate its
  productive factors on production of L-intensive
  goods and export these goods to exchange for
  K-intensive goods from the latter.
• Conversely, for the same token, the latter should
  concentrate its productive factors on production
  of K-intensive goods and export these goods to
  exchange for L-intensive goods from the former.
• By doing so the two countries can bring their
  respective comparative advantages into a full
  play and obtain trade benefits.

44
Factor Price equalization theorem(?????????)

• Price equalization theorem can be summarized
  as the followings
• A perfectly free trade between two countries will
  lead to a tendency of equalization of factor
  prices in them. If the two countries both
  practice a incomplete international
  specialization of production (?????????), i.e.
  they are both producing the two sorts of goods,
  the ultimate result of free trade must be an
  exact equalization of factor prices in the two
  countries. Such an equalization of factor prices
  could substitute, to some extent, functions of
  mobilization of factors of production between the
  two countries.

Factor price equalization theorem illustrates the
function of price mechanism in the case of
international trade. In a 222 model, according
to Heckscher-Ohlin theorem, a L-abundant country
has a relatively lower W/I ratio and thus it must
export L-intensive goods and import K-intensive
goods. Otherwise the countrys comparative
advantages could not be brought into full play
and the country could not enjoy economic benefit
from free trade.
45
Taking specific assumptions, trade will cause
changes in factor prices in factor market.

• At the same time, however, assumptions are held
  that factor endowments of the two countries are
  constant indicating the aggregate supply of
  production factors would not change.
• It is also assumed that price of production
  factors must be determined by supply-demand
  relations in a perfectly competitive factor
  market.
• Therefore, in line with trade, L-abundant Country
  As domestic production scale of L-intensive
  goods increases and that of K-intensive goods
  decreases.
• Thus in its domestic factor market demand for L
  will be relatively larger while demand for K will
  be relatively smaller.
• Taking a constant factor supply price of labor
  tends to increase and price of capital tends to
  fall.
• The opposite development will be in Country B.

(W/I)b
Wa increase while Ia decreases.
(W/I)a rises
Trade based on factor endowment
(W/I)i
Wb decreass while Ib increases.
(W/I)b falls
(W/I)a
46
Another function of trade will lead to such
relative variations in factor prices in the two
countries.
In addition, when this L-abundant country exports
its L-intensive goods and imports K-intensive
goods from its trade partner it is actually
exporting its abundant labor which is embodied in
its L-intensive exportable goods in a relatively
larger proportion while its scarce capital,
embodied in a relatively larger proportion in
K-intensive imports, is introduced from abroad.
Consequently, the degree of L-intensity and
K-scarcity of this Country will necessarily
decrease. The opposite development happens in its
trade partners economy.
So we see another function of trade Trade will
substitute factor movement between two countries,
to some extent. In other words, trade, movement
of commodities, can be concluded as movement of
factors in another form.
Such effect of trade lead to the relative
variations in factor prices in the two countries
and ultimately results in factor price
equalization between them.
(W/I)b
(W/I)i
(W/I)a
47
Ohlins conclusion on Factor Price Equalization
Theorem

• The effect of interregional trade is a tendency
  toward equalization of prices of productive
  factors.
• From each region goods containing a large
  proportion of relatively abundant and cheap
  factors are exported, and these factors therefore
  become scarcer than before, whereas, goods
  containing a large proportion of scarce factors
  are imported, and the latter factors therefore
  become less scarce.
• The same result could be obtained by a transfer
  of the factors.
• As it is, interregional trade serves as a
  substitute for such interregional factor
  movements.

48
Samuelsons Conclusion on Factor Price
Equalization Theorem

• Paul Anthony Samuelson proved the basic principle
  of factor endowment theory. He concluded in his
  famous paper International Factor-Price
  Equalization Once Again published in June 1949
  that factor price equalization is not just a
  tendency but the two exchanging nations would
  experience a complete factor-price equalization.
• The complete factor-price equalization will
  invariably influence the behavior of the rational
  producers in the two countries and, at last,
  leads to the readjustment of factor proportions.
  But such readjustment will not change the basic
  factor nature of factor intensities of the two
  goods.

Any producer must closely follow the law of
economic efficiency. It is this law that makes
such readjustment necessary.
49
Principle of Profit Maximization and Cost
Minimization
In the figure, we have an Isocost Line and
several Isoquet Curves. OP is Production
Expansion Line showing increases in production.
The tangency of Isocost Line is actually W/I
Ratio. Tangency of Isoquent Curve is really
MPL/MPK.
On Point E , the tangent point between Isocost
Line and Isoquent Curve I1, the tangency of
Isocost Line (W/I ) equals the tangence of
Isoquent Curve I1 (MPL/MPK). In this sense, we
conclude that only such tangent point represents
the most efficient production decision to meet
the requirement of the Law of Economic
Efficiency.
The Law of Economic Efficiency indicates that the
product that could be produced by the last unit
of input must equals the cost of the last unit of
input.
In other words Marginal Product equals Marginal
Cost, MPMC.
50
Pre-trade and post-trade Production Decisions
In order to meet requirement of profit
maximization and cost minimization, The two
countries readjust their production decisions
after trade because of changes in factor prices,
from a to a and from b to b, respectively.
However, such readjustment does not change the
relative factor intensities of the two goods.
Comparing the post-trade production decisions, a
and b, we see F is still relatively labor
intensive than C. In addition we also see a
tendency of factor price equalization between the
two countries.
51
Stolper-Samuelson Theorem (??????????)
W. F. Stolper and P. A. Samuelson published a
famous research paper Protection and Real Wages
in Review of Economics Studies in November 1941.
In this paper they analyzed the impact of tariff
and the other trade protection measures on trade
and distribution of income. 
They started their analysis with the assumption
that a L-abundant country will adopt particular
protection measures such as import tariff to
protect its domestic K-intensive industry. Such
protection will lead to increase price of
K-intensive Good C in its domestic market. Under
the barter system the relative price of Good C in
terms of Good F increases and the relative price
of Good F in terms of Good C decrease.
52
Effects of Trade Protection

• As trade protection develops, to some extent, to
  produce Good C would be more profitable.
• Provided that production factors are domestically
  freely mobile some factors employed in producing
  Good F, including K and L, would be induced to
  enter into C industry holding the assumption of
  full employment of production factors.
• The output of Good F reduces and more Good C will
  be produced. 
• The key point now is that factor movement from F
  industry to C industry must be carried out
  strictly following the particular production
  functions of the two industries taking production
  techniques constant.
• That means factors are proportionally removed
  from F industry in accordance with production
  function of Good F and they are also
  proportionally absorbed by C industry also
  according to production function of Good C.

53
Factor movement and changes in FPR

• Giving the previously assumed production
  functions
• F f ( 8K, 4L ) C f ( 6K, 2L )
• Or 1F 8K 4L 1C 6K 2L
• If production of Good C increases by 2 units, the
  additional K and L inputs in C industry will be
  12K and 4L, respectively.
• For the same token, reducing output of Good F by
  1 unit 8K and 4L will be released.
• Considering supply-demand relations in factor
  market we see that labor market is in equilibrium
  while demand exceeds supply in capital market.
• Non-equilibrium in capital market pushes price of
  capital to increase. Taking price of labor
  unchanged FPR, W/I, falls down. 

54
Factor movement and changes in FPR

• In order to offer more K for the extension of
  production of Good C production scale of Good F
  must be further reduced.
• For instance that 1.5 units of Good F are
  decreased and thus 12K and 6L will be released.
  The released capital could meet the additional
  requirement of increasing production of C
  industry but 2L should not be employed since only
  4L are required by C industry.
• That implies while capital market is in
  equilibrium supply of labor exceeds demand for
  it.
• Non-equilibrium in labor market results in
  decrease of price of labor. Taking price of
  capital unchanged, FPR, W/I, falls down again.
• It is obviously concluded that protection
  policies will greatly influence distribution of
  income among the owners of different production
  factors.

55
How does import tariff protection affect income
distribution
I rises while W falls
Pc increase while Pf decreases.
Import Tariff Protection on Good C
Owners of K take more while owners of L loss in
income distribution.
It is more profitable to produce the protected
good.
Taking the assumption of factor full employment
SltD in K market while SgtD in L market.
Output of Good C increases while output of Good F
decreases.
production functions must be strictly followed.
Factor movement from Industry F to Industry C
56
No Good for Development of Trade

• Changes in relative price of one good in terms of
  the other derived from protection policies must
  have impacts on trade of a country.
• In the above instance the country would have
  comparative advantages in F industry since it is
  Labundant country and thus it will export
  L-intensive Good F while import K-intensive Good
  C.
• Implementing protection policies its domestic
  production of Good F reduces and that of Good C
  increases. This countrys willingness of
  participating trade must be dammed other things
  constant.
• That means protection policies are no good for
  development of trade.

57
Reasons in Depth of Different Trade Policies

• Combining Stolper-Samuelson Theorem with
  Heckscher-Ohlin Theorem we can observe in depth
  the economic doctrine behind particular trade
  policies, free trade vs. trade protection,
  adopted by particular countries in certain
  historic stages or by particular interest groups
  in a given country.  
• Generally speaking those countries enjoying some
  comparative advantages firmly support free trade
  policies while the other countries being
  comparatively disadvantageous advocate protection
  policies.
• The interest groups whose industries are
  comparatively advantageous hold high the banner
  of free trade while the other interest groups
  whose industries are comparatively
  disadvantageous insist to take possible
  protectionist measures.

58
Rybczynski Theorem(???????)

• A British economist T. M. Rybczynski published
  his research paper, Factor Endowment and Relative
  Commodity Prices, in Economica, November 1955.
• In this paper Rybczynski analyzed relations
  between variations in factor supply and trade
  equilibrium in a small country model by using the
  famous Edgeworth Box introduced by another
  respective British economist, F. Y. Edgeworth.
• Rybczynskis research changed one of the basic
  assumptions of factor endowment theory, supply of
  production factors are constant.
• In this sense, what Rybczynski did was a new
  exploration of factor endowment theory.

59
Conclusions of Rybczynski Theorem

• There are two basic conclusions of the theorem
• (1) With the given factor proportion of
  production in a small country model when talking
  about only two sorts of factors increase in a
  particular factor supply causes production of
  commodity intensively embodied that sort of
  factor to increase in an even larger extent and
  production of the other factor-intensive
  commodity absolutely decreases.
• (2) When a countrys abundant factor supply
  increases its terms of trade will be
  deteriorated while a country increases its scarce
  factor supply will cause improvement of its terms
  of trade.

60
Edgeworth Box

• In an autarky economy when two sorts of factors
  are used to produce two kinds of goods, each of
  them is of a particular factor intensity, the
  optimum factor allocation requires (1) full
  employment of production factors and (2) factors
  are allocated in such a way that it is impossible
  to increase output of one good without decreasing
  output of the other good.
• In an Edgeworth Box, only those tangent points
  between Isoquent Curves, respectively
  representing giving output production of
  particular good, stand for the optimum allocation
  of production factors.

A rational producer must behave strictly
following the Law of Economic Efficiency. That
indicates a country most efficiently produces the
two goods only when the ratio between marginal
product of labor and capital in producing the
two goods are exactly equal to each other.
On those tangent points ( MPL / MPK )F ( MPL /
MPK )C
61
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62
Impacts of labor supply increases in a
labor-abundant country.
A labor abundant Country H and a capital abundant
Country F to produce labor-intensive Good U and
capital-intensive Good V.
Suppose that labor supply in Country H increases.
Taking other things constant, the relative
variations of its domestic production structure
lead to changes in its trade structure.
Exports of its labor-intensive Good F increases
while its imports of Country Vs
capital-intensive Good C increases at the same
time.
OH curve moves outward to OH . Trade equilibrium
point changes from E to E. Its terms of trade
deteriorated from OT to OT.
63
Immiserizing Growth in a large country model
64
Questions and Problems

•  Briefly describe the basic doctrine of factor
  endowment theory.
• What is the cause of trade in accordance with
  factor endowment theory? How to understand the
  linkage and difference between the classical
  trade theory and factor endowment theory?
• How can we correctly conclude a countrys factor
  endowment and factor intensity of a given
  product? Try to raise an example to illustrate
  the application of the two definitions, physical
  and economic?
• Try to illustrate the basic meaning of
  Heckscher-Ohlin Theorem in a graphical manner.
• Why will trade ultimately lead to equalization of
  factor prices in the two trade partners?
• Try to reveal the economic background of
  different trade policies taken by different
  interest groups of a country or by different
  countries in the same period. Why dose a specific
  country take different trade policies in
  different periods?
• Try to graphically illustrate basic ideas of
  Rybczynski Theorem and the effect of changes in
  a countrys factor supply on terms of trade.