If all assumptions hold true, how does trade between nations tend to bring about equalisation of factor prices?

The Heckscher-Ohlin Model and its Assumptions

The Heckscher-Ohlin (H-O) theorem, developed by Eli Heckscher and Bertil Ohlin, states that a country will export goods that use its abundant factors intensively and import goods that use its scarce factors intensively. This model rests on several key assumptions:

• Two countries, two factors, two goods: Simplification for analytical clarity.
• Identical technology: Both countries have access to the same production techniques.
• Constant returns to scale: Increasing inputs proportionally increases output.
• Perfect competition: No monopolies or market distortions.
• Factor mobility within countries, but immobility between countries: Factors can move freely within a country but cannot migrate internationally.
• No trade barriers: Free flow of goods between countries.

Mechanism of Factor Price Equalization

Under these assumptions, trade leads to factor price equalization through the following mechanism:

1. Changes in Relative Demand

When countries trade, the demand for factors used intensively in exported goods increases, while the demand for factors used intensively in imported goods decreases. For example, if Country A (capital-abundant) exports capital-intensive goods to Country B (labor-abundant), the demand for capital increases in Country A and the demand for labor increases in Country B.

2. Impact on Factor Returns

Increased demand for a factor raises its price (return). In Country A, the increased demand for capital drives up the return on capital. Conversely, in Country B, the increased demand for labor drives up wages. This process continues until the returns to factors are equalized across countries.

3. Stolper-Samuelson Theorem

The Stolper-Samuelson theorem, a corollary to the H-O model, states that trade will increase the return to a country’s relatively abundant factor and decrease the return to its relatively scarce factor. This further reinforces the equalization process.

Illustrative Example

Consider two countries: the US (capital-abundant) and India (labor-abundant). The US specializes in and exports capital-intensive goods like machinery, while India specializes in and exports labor-intensive goods like textiles. This increases the demand for capital in the US, raising returns to capital owners. Simultaneously, it increases the demand for labor in India, raising wages. Over time, this process tends to narrow the gap in capital returns and wage rates between the two countries.

Limitations and Deviations

Despite the theoretical elegance, complete factor price equalization rarely occurs in the real world due to:

• Transportation costs: These create a wedge between prices in different countries.
• Trade barriers: Tariffs, quotas, and other restrictions impede free trade.
• Differences in technology: Technological disparities affect factor productivity.
• Factor mobility: While assumed immobile between countries, some degree of labor migration and capital flows do occur.
• Non-constant returns to scale: Economies of scale and other factors can disrupt the model’s predictions.

Empirical evidence suggests that factor price convergence is more pronounced for relatively similar countries and for factors that are more mobile (e.g., skilled labor).