Factor price equalization

Factor price equalization is an economic theory, which states that the relative prices for two identical factors of production in the same market will eventually equal each other because of competition. The price for each single factor need not become equal, but relative factors will. Whichever factor receives the lowest price before two countries integrate economically and effectively become one market will therefore tend to become more expensive relative to other factors in the economy, while those with the highest price will tend to become cheaper.

An often-cited example of factor price equalization is . When two countries enter a free trade agreement, wages for identical jobs in both countries tend to approach each other. After the North American Free Trade Agreement (NAFTA) was signed, for instance, unskilled labor wages gradually fell in the United States, at the same time as they gradually rose in Mexico.Fact|date=April 2008 The same force has applied more recently to the various countries of the European Union.

The result was first proven mathematically as an outcome of the Heckscher-Ohlin model assumptions.

Simply stated the theorem says that when the prices of the output goods are equalized between countries as they move to free trade, then the prices of the factors (capital and labor) will also be equalized between countries.

This implies that free trade will equalize the wages of workers and the profits earned on capital throughout the world.

The theorem derives from the assumptions of the model, the most critical of which is the assumption that the two countries share the same production technology and that markets are perfectly competitive.

In a perfectly competitive market the return to a factor of production depends upon the value of its marginal productivity. The marginal productivity of a factor, like labor, in turn depends upon the amount of labor being used as well as the amount of capital. As the amount of labor rises in an industry, labor's marginal productivity falls. As the amount of capital rises, labor's marginal productivity rises. Finally the value of productivity depends upon the output price commanded by the good in the market.

In autarky, the two countries face different prices for the output goods. The difference in prices alone is sufficient to cause a deviation in wages and rents between countries, because it affects the marginal productivity. However, in addition, in a variable proportions model the difference in wages and rents also affects the capital-labor ratios in each industry, which in turn affects the marginal products. All of this means that for various reasons the wage and rental rates will differ between countries in autarky.

Once free trade is allowed in outputs, output prices will become equal in the two countries. Since the two countries share the same marginal productivity relationships it follows that only one set of wage and rental rates can satisfy these relationships for a given set of output prices. Thus free trade will equalize goods prices and wage and rental rates.

Since the two countries face the same wage and rental rates they will also produce each good using the same capital-labor ratio. However, because the countries continue to have different quantities of factor endowments, they will produce different quantities of the two goods.

ee also

* List of international trade topics