Factor price equalization
Encyclopedia
Factor price equalization is an economic
theory, by Paul A. Samuelson (1948), which states that the relative price
s 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 wages. 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
. 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 theory was independently discovered by Abba Lerner in 1933 but was published much later in 1952.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
theory, by Paul A. Samuelson (1948), which states that the relative price
Relative price
A relative price is the price of a commodity such as a good or service in terms of another; i.e., the ratio of two prices. A relative price may be expressed in terms of a ratio between any two prices or the ratio between the price of one particular good and a weighted average of all other goods...
s for two identical factors of production
Factors of production
In economics, factors of production means inputs and finished goods means output. Input determines the quantity of output i.e. output depends upon input. Input is the starting point and output is the end point of production process and such input-output relationship is called a production function...
in the same market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...
will eventually equal each other because of competition
Competition
Competition is a contest between individuals, groups, animals, etc. for territory, a niche, or a location of resources. It arises whenever two and only two strive for a goal which cannot be shared. Competition occurs naturally between living organisms which co-exist in the same environment. For...
. 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 wages. When two countries enter a free trade
Free trade
Under a free trade policy, prices emerge from supply and demand, and are the sole determinant of resource allocation. 'Free' trade differs from other forms of trade policy where the allocation of goods and services among trading countries are determined by price strategies that may differ from...
agreement, wages for identical jobs in both countries tend to approach each other. After the North American Free Trade Agreement
North American Free Trade Agreement
The North American Free Trade Agreement or NAFTA is an agreement signed by the governments of Canada, Mexico, and the United States, creating a trilateral trade bloc in North America. The agreement came into force on January 1, 1994. It superseded the Canada – United States Free Trade Agreement...
(NAFTA) was signed, for instance, unskilled labor wages gradually fell in the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
, at the same time as they gradually rose in Mexico
Mexico
The United Mexican States , commonly known as Mexico , is a federal constitutional republic in North America. It is bordered on the north by the United States; on the south and west by the Pacific Ocean; on the southeast by Guatemala, Belize, and the Caribbean Sea; and on the east by the Gulf of...
. The same force has applied more recently to the various countries of the European Union
European Union
The European Union is an economic and political union of 27 independent member states which are located primarily in Europe. The EU traces its origins from the European Coal and Steel Community and the European Economic Community , formed by six countries in 1958...
.
The result was first proven mathematically as an outcome of the Heckscher-Ohlin model
Heckscher-Ohlin model
The Heckscher–Ohlin model is a general equilibrium mathematical model of international trade, developed by Eli Heckscher and Bertil Ohlin at the Stockholm School of Economics. It builds on David Ricardo's theory of comparative advantage by predicting patterns of commerce and production based...
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 theory was independently discovered by Abba Lerner in 1933 but was published much later in 1952.