Factor Price Equalization - YouTube

Now, let's consider the topic of factor price equalization.

What's at stake here are the returns to labor and the returns to capital.

And the question is, to what extent trade tends to bring those returns closer together?

Across nations, that is.

So, for instance, in this application,

if the United States starts trading with China,

what we would expect is that wages rise in China,

initially the lower wage country,

and, in turn, wages fall in the United States.

That represents some degree of factor price equalization.

There are more specific and more formal versions

of factor price equalization theorems,

and they tend to be put in what's called a Heckscher-Ohlin setting.

That is, we can postulate two countries, two goods and two factors,

and each of those two countries will have some comparative advantage

based on whether it has more capital or more labor.

For more on this, see our videos on the Heckscher-Ohlin theorem.

In any case, the extreme result of true factor price equalization

is a polar result based on some extreme assumptions.

So, imagine you have perfect competition, free trade,

identical technologies around the globe, and no transportation costs.

Well, if it were the case that wages were lower in China,

why would you invest in the United States?

Put all your investment in China,

build the goods and services in China,

and then ship them to the United States until the wages in the two countries

would be exactly equal.

In this setting, trade really is managing to equalize factor prices

through a mechanism of arbitrage.

The thing is, as a general result,

factor price equalization is very far from true.

In a lot of goods and services,

the United States and China have free trade or nearly free trade,

and still,

wages in the United States are many times higher than wages in China.

One reality which violates the assumptions of the theorem;

simply the notion of different technologies.

America has some more productive technologies than China,

and America also has some very different institution.

Great Britain has different institutions than, say, Italy,

and again, you do not see wages equalizing

even though those two countries have nearly free trade.

A weaker version of factor price equalization

is the Stolper-Samuelson theorem which states, namely, that

"a change in the price of a traded good results in a more than proportional change,

in the same direction,

in the price of the factor that is used in the production of that good more intensively."

To make this approach more concrete,

imagine that trade opens up between, say, the U.S. and China.

The theorem is predicting,

wages rise in China, fall in the United States.

Capital returns rise in the United States, fall in China.

But here's the key part.

The returns to the factors will change more in percentage terms

than the goods prices will change.

Let's consider the intuition here.

Let's say that the opening of trade causes a price to fall,

and that's a price for the labor intensive good coming from China.

It's the case in the theorem that, in the U.S.,

the return to capital is rising

and the return to labor is falling.

Because we've assumed perfect competition,

basically, prices of goods have to be equal to their costs of production.

So, if we have a price of something that is falling

and we already know that, in the U.S., the return to capital is rising,

well, the return to labor has to be falling all the more

than the change in the price of the good.

And that is sometimes called the magnification effect.

You might wonder, well, how true is that theorem?

And actually, overall in the data, it doesn't appear to be very true at all.

So, for instance, the prices of iPhones across different countries

have converged much more than wages across different countries.

Or try buying Big Macs around the world in different countries.

The prices are somewhat different but they're not that far apart.

Wages seem, across countries, much further apart

than, say, the prices of Big Macs.

So, the Stopes-Samuelson results;

it's considered an interesting analytical proposition,

a way of thinking about relationships.

But in general, it's not considered that good a description

of the actual real world.

For more on these topics, you can google "factor price equalization"

and "Stolper-Samuelson theorem".

In general, this is a highly mathematical literature

and the level of math goes beyond what we're offering in this course.

If you'd like to see several pages of working through of one algebraic example,

you can consult the Feenstra and Taylor book on the Stolper-Samuelson theorem.

There's also a good technical piece by John Chipman on the relationship between

factor price equalization and Stolper-Samuelson.

And, really, for a more concrete approach to some of these topics,

I would recommend our videos on offshoring and also our video called

"Trade Migration and Investment as Substitutes".