3.

MODERN THEORY OF INTERNATIONAL TRADE

EXPECTED LEARNING OUTCOMES
After learning the contents in this chapter, students will be able to:
•Analyze the factor endowment theory (Heckscher-Ohlin theorem)
and its predictions about the structure of international trade based
on the price and physical criteria of defining factor abundance..
•Compare the validity of the H-O theorem under price and physical
criteria.
•Critically evaluate the validity of the H-O theorem based on the
factor intensity reversal argument, the demand reversal argument
and the Leontief's paradox.
•Analyze the basic principles and ideas of factor price equalization
theorem base on the Edgeworth-Box graphical analysis.
•Critically evaluate the validity of the factor price equalization
 Introduction
•The two main propositions of the modern theory of international trade
are the Factor-Endowment theory (Heckscher-Ohlin theorem, hereafter
named H-O theorem in this module) and the Factor-Price equalization
theorem.

•The Factor-Endowment theory (H-O Theorem) this theory states

that countries produce and export goods and services that intensively
uses factor of production which abundantly found in the country. .i.e.
the commodities for which countries comparative advantage is higher
when compared with others.

•The Factor-Price Equalization Theorem: According to this theory

the role of international trade is balancing or equalization of price of
factor of production (wage for labor and interest rate for capital)
between countries. Thus, the international trade can service as
 The H-O Theorem (Factor-Endowment theory) and its Assumptions
• Recent contributions to the pure theory of international trade
have relied heavily on the factor proportions analysis developed
by the two Swedish economists, Eli Heckscher (1919) and Bertil
Ohlin (1933).
• According to their theory, the immediate cause of international
trade is, the differences in the relative prices of commodities
between the countries, and these differences in the commodity
prices arise on account of the differences in the factor supplies
(endowments) in the two countries.
The H-O model is based upon the following assumptions:
• There are only two factors of production-labor and capital.
• There are only two countries and they are different in factor
abundance, e.g. one country is capital abundant but labor scarce
and the other country is labor abundant but capital scarce.
 The H-O Theorem (Factor-Endowment theory)Assumptions
• There are only two commodities. Both goods involve the use of both
factors.
-The production functions are such that the relative factor intensities
are the same for each good in the two countries.
- In other words, regardless of what the factor proportions or factor
prices are in the two countries, one commodity is always capital
intensive in both countries and the other commodity is labor
intensive in both countries.
• On the basis of these assumptions, the H-O theorem predicted that:
- the capital surplus country specializes in the production and
exports of capital intensive goods, and
- the labor surplus country specializes in the production and exports
of labor intensive goods.
• We will now proceed to demonstrate this well-known structure of
trade prediction of the H-O model. In order to demonstrate this
prediction we need to define the term factor abundance.
 Factor Abundance
•term
There are two alternative definitions that have been given for the
'factor abundance based on the criterion used to define the
term. These are price criterion and physical criterion.
i. The Price Criterion

•relatively
According to this "price criterion" a country in which capital is
cheap and labor is relatively more expensive, is regarded
as the capital abundant country, regardless of the physical
quantities of capital and labor available in this country compared
with the other country;
•In the same way, a labor abundant country would be defined as
one where labor is relatively cheaper and capital is more
expensive.

•supply
For the fact that price of a factor is the result of demand and
forces in the factor market, this criterion takes into account
the supply and demand conditions for the two factors of production
 ii. The Physical Criterion
•criterion",
Factor abundance can be defined in physical terms. According to the "physical
a country is relatively capital abundant if and only if it is endowed
with a higher proportion of capital to labor than the other country. In other
words, if the capital to labor ratio of country A is larger than the capital to labor
ratio of country B, country A is a capital surplus country and country B is a
labor surplus country.

•as
This criterion takes into account only the supply (physical quantities) of factors
a base for defining factor abundance. It does not take factor demand into
account.

• Note that, these two alternative definitions are not equivalent. As (H-O)
prediction is with regard to the structure of trade, it holds only if we use the
price criterion but it does not necessarily hold well if we use the physical
criterion to define factor abundance.

•thought
Ohlin himself defined relative factor abundance using the price criterion. He
that if capital is relatively cheap relative labor in one country, that
country must be abundant in capital supply; and vice versa.
• It now remains for us to show that one country, say country A, is capital
abundant and it exports capital-intensive good, and the other country, say
 Price Criterion of Factor Abundance and the Structure of trade
Starting from the definition of factor abundance in terms of factor prices, it is easy to establish
the H-O theorem. It is easily demonstrated in figure 4.1. The two factors-capital (K) and labour
(L) are measured along the vertical and horizontal axis, respectively. The set of factor price
ratios (isocost curves) in country A, a capital surplus country, are shown by the parallel isocost
lines P0P0 and P0'P0'. The slope of the isocost curve shows the factor price ratios in country A
K PL
( Slopeof Iso cos t curve   ). The relative steepness of these lines reflects the fact that
L PK

capital is cheaper and labor is dearer in country A. Similarly, the lines P1P1 and P1'P1' reflect the
factor price ratios (isocost curves) in country B. The relative flatness of these lines shows that
labor is cheap and capital is expensive in country B, a labor surplus country.
• Then we have the two iso-quants labeled
aa and bb, and the two isoquants cut each
other only once, i.e. at point Q.
• This indicates that there is no reversal of
factor intensity, meaning that one
commodity is capital intensive in both the
countries (K good represented by the
isoquant aa) and other commodity (Good
represented by the isoquant bb) is labor
intensive in both countries.
• This is in conformity with the H-O
assumption that the production functions
are identical for each good in the two
countries.
 i. Cost of Production in Country A
• The cost of producing one unit of K good is made up of HD amount of
capital plus HF amount of labor, because at point H there is a tangency
between the iso-cost curve P0P0 and the isoquant for K good.
•The cost of producing one unit of L good consists of OF=JE amount of
capital (which is equal to the capital unit required to produce the K-
good) but more labor viz. OE amount of labor (as against OD amount
needed to produce one unit of K good).
•In other words, in country A, in order to produce one unit of L good,
you need to use the same amount of capital as in K good (viz. HD=JE =
OF) but more labor (OE as against OD). In other words, the isoquant
curve of K-good is tangent at the lower iso-cost curve whereas, the
isoquant curve of L-good is tangent to the upper iso-cost curve of
country A.
•This implies producing K-good is cheaper than producing L-good in
country A. Hence the capital surplus country (country A) would
specialize in the production and exports of capital-intensive good (K
good). K-good is capital intensive and L-good is labor intensive to both
country A and B due to a higher capital to labor ratio in K-good
 i. Cost of Production in Country A
Cost of Production in Country B 2
• The cost of producing one unit of L
good is made up of OT = MG amount
of capital plus OG amount of labor,
but the cost of producing one unit of K
good consists of the same amount of
To sum up: 3 labor but more amount of capital i.e.
ON = RG (as against OT=MG needed
•Factor price ratios in country A and to produce one unit of K good).
B are different, which reflects that •This means that country B can
country A is capital-abundant and produce L good at a relatively lower
country B is labor-abundant, cost of production per unit.
•One commodity is capital intensive •Therefore, country B (a labor
in both countries (viz. K good) and surplus country) would specialize in
the other commodity is labor the production and exports of L good
intensive in both countries (L good). (a labor intensive good).
 To sum up
Thus, starting from the definition of factor abundance in terms of factor
prices, (or price criterion) it is easy to establish the H-O theorem.
Incidentally, we might also say that reverse of the theorem also holds
well, i.e. if a country exports capital intensive good, then capital must
be its cheaper factor of production. Likewise, if a country exports labor-
intensive good, then labor must be a cheaper factor of production in
that country.
One could argue, however, that stating the theorem in terms of factor
prices, is not very interesting, because factor prices are themselves the
result of a complicated interplay of economic forces- particularly of
demand for and supply of the factors of production.
From the mere knowledge of factor endowments alone it is not possible
to say anything precisely about factor prices. Therefore, to state the H-
O theorem in terms' of factor prices (using the price-criterion) does not
give, perhaps, the most interesting explanation of the theorem.
 A more natural definition of factor abundance, it appears would run in
terms of physical amounts. We shall now turn to the physical criterion
and see what the results would turn out to be:
 Physical criterion of factor abundance and the structure of trade
According to this criterion country A is capital abundant and B is
labor abundant if the capital to labor ratio of country A is greater
than the capital to labor ratio of country B.

Symbolically:
Where KA and LA are the total amounts of capital and labor,
respectively, in country A, and KB and LB are the amounts of,
capital and labor, respectively, in country B.

We will now show that country A, a capital abundant country by

the physical criterion of abundance, has a bias in favor of
producing the capital-intensive good; and that country B, a labor
abundant country will have a production bias in favor of labor-
intensive good production.
Physical criterion of factor abundance and the structure of trade
Figure 4.2 reflects the nature of these biases
in the two countries in respect of the two
goods.
The production possibility curve of country
A is AB and that of country B is CD. We
assume that steel is the capital intensive
good and Cloth is the labor intensive good.
Suppose, the two countries produce the
goods in the same proportion-along the ray
OR- then country A would produce at Q 1 and
country B at Q2 on their respective
production possibility curves.
Note that the slope of country A's
 Continued
Similarly, the commodity price line P1P1 is steeper than the line P2P2.
All this implies that steel production is cheaper in country A and cloth
production is cheaper in country B, if the two countries are producing at Q1
and Q2 respectively. Country A would, therefore, tend to expand production
of steel and country B would do so for cloth.
This means that country A has a bias in producing more steel than cloth
and B has a bias in producing more cloth than steel.

Does it follow from this that country A would export steel and country B
would export cloth? The answer depends very much upon the demand
(consumption) factors in each country. This gives rise to two possibilities:
-If the consumption bias and the production bias are towards the same
direction, then country A would import rather than export steel and
country B would import rather than export cloth. The H-O prediction
would then be invalid,
-If the consumption and production biases are in the opposite
direction, then the H-O prediction will be valid, viz. country A would
export steel and country B would export cloth. Let us illustrate these two
 Production and Consumption biases in opposite direction
As depicted in figure 4.3 below, after the establishment of trade
between the two countries, country A's production shifts to point A
(towards greater production of steel), and country B's production
shifts to point B (towards greater production of more cloth).
This means that the capital surplus country (country A) specializes in
the production of the capital-intensive good (steel), and the labor
surplus country (country B) specializes in the production of the labor-
intensive commodity (cloth).
There is greater degree of specialization but by no means complete
specialization, in the two countries, because of the diminishing return
to scale conditions in the two countries in respect of both the goods.
Figure 4.3 shows that the line PP stands for the international terms of
trade line, which is also the relative factor price ratio line after trade
is established between the two countries.
(Note incidentally that factor prices will be equalized as a result, of
trade). We shall discuss this later under factor price equalization
theorem, which is the second proposition of the Modern theory of
Continued
•If the demand biases in the two countries are
in opposite direction such that we have an
indifference curve like IC in figure 3.3, the H-O
theorem and its prediction about the structure
of trade will hold good.
•The two countries produce at points A and B
but consume at point C.
•It is important that consumption point, 'such as
point C, must lie to the right of point A but to
the left of point B (implying opposite direction
in production and consumption biases in each
country) in order for H-O prediction to be valid.
•In this case, it has happened in figure 3.3.
 Continued
• Country B exports DB units of cloth and imports CD units of steel. The
capital surplus country, therefore, is exporting capital intensive good
and it is importing labor-intensive good.
• Similarly, the labor surplus country is exporting labor-intensive good
and it is importing capital-intensive good. In this case, therefore, the
H-O prediction would be valid.
• We emphasize that it is important that consumption should take place
to the right of where the production is taking place in country A, and to
the left of where the production is taking place in country B.
• Only then the two countries will specialize in the production as well as
export of the commodities which involve intensive use of their
respectively abundant factors of production.
 Continued
• It is by no means necessary that the taste pattern in the two countries must be
identical. In figure 3.3, we have made that assumption in drawing a common
indifference curve IC both for country A and country B, but it is not necessary.
• This would only mean that country A is consuming at point R while it produces at
point A, and that country B is producing at point B and consuming at point T.
• Nevertheless, country A exports steel (equal to AH amount) and imports cloth
(equal to HR amount); and country B exports FB amount of cloth and imports TF
amount of steel.

• Therefore, as long as the consumption points lie to the right of where production
is taking place in country A and to the left of where the production is taking place
in country B, the H-O prediction concerning production specialization as well as
commodity composition of exports and imports by countries would perfectly hold
good.
 ii. Production and consumption biases in same direction
• This case is illustrated in figure 3.4. The figure reproduces the same information as in
figure 3.3, except that in figure 3.4, the demand in country A is biased toward the
capital-intensive good and that in country B the demand is biased toward the labor-
intensive good. Therefore, as a result, country A produces at point A, specializing in
the production of steel.
• It consumes at point D, given the utility pattern represented by indifference curve IC A,
This means that country A exports EA amount of cloth and imports ED amount of steel.
• Therefore, country A which is a capital surplus country is exporting labor-intensive
good (cloth) and importing capital-intensive good (steel). This is in direct conflict with
the H-O prediction concerning the commodity structure of trade.
• Likewise, country B specializes in the production of cloth; it produces at point B. But it
consumes at point G in response to its utility pattern represented by the indifference
curve ICB.
 Continued
• Steel
Therefore, it exports BF
D ICA

A
amount of steel and imports
P E
ICA1

ICB1
FG amount of cloth.

B
Once again we notice that

F
G
ICB country B, which is a labor-
O

Cloth
P
surplus country exports
Figure 3.4: Consumption and production biases in same direction
capital-intensive good (steel)
and imports labor-intensive
good (cloth).
 iii. Autarky Situation
• If, on the other hand, the demand patterns are not identical that
the indifference curve of country A is tangent at point A (as shown
by ICA1 in figure 3.4) and the indifference curve of country B is
tangent at point B (also shown by ICB1 in figure 3.4), then it would
mean that

• country A and B choose to consume where they produce. There

will then be no trade, but a situation of autarky.
• In such an event, the H-O prediction will still be valid but, only
insofar as it related to production specialization but not structure
of trade. There, will, in fact, be no trade to speak of.
 Critical evaluation of the H-O
theorem
• Although the factor proportions theorem developed by Heckscher and Ohlin
provides a thorough and plausible explanation of international trade as
compared with the classical comparative advantage model, yet it is not free
from criticism.
• The H-O theorem has been criticized mainly along the following three lines of
arguments.

-Factor intensity reversal argument

-Leontief’s Paradox, i.e. the results obtained by empirical tests
conducted by Leontief and others on the capital to labor ratios of
exports and imports of developed countries like USA and Japan.
-Demand reversal argument. We have already seen how the H-O theorem
 i. Factor intensity reversal argument
• The H-O theorem was based on the assumption of no factor intensity reversal. That is,
the production functions are different for different goods but they are identical for each
good in the two countries.

• This, in other words, means that one good is capital intensive (with higher capital-labor
ratio) and the other good is labor-intensive (with lower capital-labor ratio); but the same
good, which is capital-intensive in one country, must be capital intensive in the other
country also, and the labor intensive good remains labor intensive in both countries.

• This assumption is guaranteed when the two production isoquants of the capital-
intensive and the labor intensive goods-cut each other only once but not more than
once.

• In figure 3.1, this is shown to happen at point Q. The demonstration in this figure is
consistent with the H-O assumption of non-reversibility of factor intensities.
 Continued
• If factor intensity reversal takes place, then the two isoquants would
cut each –other at more than once and the H-O theorem would turn
out to be invalid.

• This case is demonstrated in figure 4.5. The two production

isoquants for steel and cloth cut each other twice in figure 4.5 once
at point A and the second time at point B.

• The factor price ratios in country A (capital surplus country) are

represented by the parallel lines P0 and P’0 whereas P1 and P’1
represent the factor price ratios in country B (labor surplus country).
 Continued
In figure 3.5, note the following factors.
In country A, steel is labor-intensive and cloth is capital
intensive. To produce 1 unit of either steel or cloth, country A
has to use the same amount of capital but more labor for steel
than for cloth. Cloth has a higher capital labor ratio and steel
has a lower capital labor ratio. Therefore, a capital rich country
like country A would specialize in the production and exports of
the capital intensive good, which is cloth. It would import steel
which is a labor intensive good.
 In country B, cloth is a labor intensive good and steel is a
capital intensive good. Because, to produce one unit of cloth, it
takes a given amount of labor and smaller amount of capital as
compared to steel. Steel takes the same amount of labor but
more capital per unit of output. In country B, therefore, steel has
a higher capital labor ratio than in cloth. Naturally, country B
 Continued
• In this case of factor intensity reversal, as we saw above, both the countries
produce and export the same commodity i.e. cloth. In the capital rich country,
(country A) it is a capital-intensive product, and in the labor rich country,
(country B) it is a labor-intensive product. That means the same product (viz.
cloth) is capital-intensive in one country but labor-intensive in the other.
• The same thing applies to steel as well. Steel is a labor intensive product in
the capital rich country (country A), and it is a capital-intensive product in
the labor rich country (country B). This is a situation of factor intensity
reversal.
• When this takes place, both countries end up producing and exporting the
same commodities (cloth) and importing the other commodity steel. This
would invalidate the H-O prediction regarding the structure of commodity
trade.
 i. Leontief paradox
• The first comprehensive and detailed examination of the H-­O theorem
was the one undertaken by Leontief. You will recall that the theory of
factor proportions predicted that the capital abundant country
exported capital-intensive goods and imported labor-intensive goods,
and the labor surplus country did the opposite.
• It is commonly agreed that the United States is a capital rich and
labor scarce country. Therefore, one would expect exports to consist
of capital-intensive goods and imports to consist of labor-intensive
goods.
• Leontief made an extensive study of the US structure of trade and the
results were startling. Contrary to what the H-O theory had predicted,
Leontief’s study showed that the US exports consisted of labor-
intensive goods and the imports, (or more precisely import competing
products) consisted of capital-intensive goods.
• In Leontief’s own words, "America's participation in division of labor in
international trade is based on its specialization in labor intensive
rather than capital-intensive lines of production. In other words, the
country resorts to foreign trade in order to economize its capital and
 Continued ii. Demand reversal argument
Leontief’s findings are summarized in the • As we have discussed in figure 3.4
following table:
Exports Imports above, if production and consumption
Replacements
Capital (US $ in 1947 prices) 2550780 3091339 biases operate in the same direction in

Labor (man years) 180313 170004 each country, a capital surplus country

Capital Labor ratio (US $ per 13911 18185

will go for specializing in the
man hour)
production of capital intensive good

• From the, above table, it is obvious but it will export a labor intensive
that the US exports had a lower good and a labor surplus country will
capital-labor ratio than the import go for exporting capital intensive
replacements.
good.
• Note carefully that these are
• This structure of trade is contrary to
import replacements produced in
 The factor-price equalization theorem
• The factor-price equalization theorem states that the effect of trade is to equalize
factor prices between countries, thus serving as substitute for international factor
mobility.
• This theorem has enjoyed far less limelight than the H-O theorem. Nevertheless, it
has attracted considerable attention from well-known economists. Heckscher
(1919) stated that free trade equalizes factor rewards completely.
• Ohlin (1933), on the other hand argued that full factor-price equalization cannot
occur in practice. Ohlin asserted that free trade brings about only a tendency
towards factor-price equalization, and only partial factor-price equalization is
possible.
• The later models by Stolper and Samuelson (1941) and Uzawa (1959) also support
partial equalization thesis. The later works of Samuelson (1948, 1949, and 1953)
 Assumptions of the theorem
• In order to demonstrate how the factor-price equalization takes place as a result of
international trade, we will use:
 A model of two countries (country A and B),
 Both countries produce commodities (goods X and Y) and
 There are two factors of production (capital K, and Labor, L) used in each country to
produce commodities X and Y.
 Before trade (i.e. in a situation of autarky) we have the following situations:
o In country A, a labor surplus country, labor is abundant and cheap and capital is scarce and
expensive. Therefore, the K/ L (or capital labor ratio) is rather low.
o And once the trade is opened up, labor becomes relatively scarce and the price of labor will go
up.
o Similarly, capital becomes relatively abundant and hence the cost of capital will go down. This
follows directly from the H-O theorem that the labor surplus country will specialize in the
production and exports of labor-intensive goods.
o In other words, the abundant factor becomes scarce and the scarce factor becomes abundant,
relatively so that (after trade) the K/ L will go up in country A.
 Assumption
o In the capital surplus country-country B-the pre-trade situation is such that capital is abundant
and cheap, and labor is scarce and therefore expensive. The K / L will be high before trade. But
after trade, this ­country will specialize in the production of capital-intensive goods, so that the
demand for capital will rise relative to that of labor. This will result in capital becoming scarce
and the cost of capital going up, and labor becoming abundant and the cost of labor going down.
The K / L will drop as a result.

•In brief, we start with a low capital-labor ratio in country A and a high capital-labor ratio
in country B. This is before trade. But after trade capital ratio will rise in country A and
fall in country B until the capital ratios are equalized in the two countries. This is the
process by which the factor prices (capital-labor ratios) in the two countries are
equalized as a result of trade. Note that this factor-price equalization is brought about
without the movement of factors of production between the two countries. What brings
about this factor price equalization, then, is the international trade mechanism. It is in
this sense that we can argue that international trade in goods and services, is a
substitute for international labor and capital movements (or factor mobility).
 Continued
• We shall now explore the meaning and process of how this
factor-price equalization will, in fact, be brought about. We will
do it with the help of Edgeworth-Bowley box diagrams.
• The points of origin for Good X and Good Y are as shown in
figure 3.6. Capital and labor are measured along the horizontal
and vertical sides of the above box diagram.
• The base of the box is larger than the height representing a
labor surplus country since it has more supply of labor than of
capital.
Continued.
• There are three possibilities with regard to the
capital-labor ratio (K/ L) in the production of good X
and Good Y:
which is shown by the equality of BAˆ C and ABˆ D
the angles .
• A Straight Line Contract Curve: If the optimum-
efficiency locus (or the contract curve) is a linear
straight line, such as AB, the capital-labor ratio in
the two goods will be equal and remain so
regardless of whether more of X is produced or
more of Y is produced.

• In other words, whether we produce at point 1 or 2

or 3 on the line AB, the capital-labor ratio in good X
will be equal to the capital-labor ratio in good Y,
which is shown by the equality of the angles.
Continued
 Continued
• Throughout what follows, we will assume that the contract curve is of the type
represented by the non-linear line ATB so that good X is labor intensive and good Y is
capital intensive.

• Even if the country had more capital and less labor, good X will remain labor-intensive
and good Y capital-intensive, so long as we have a contract curve of the shape of ATB
as shown in figure 3.6. This would mean that in our model:
 country A is a labor­surplus country and country B is capital-surplus country,
 Good X is labor-intensive and good Y is capital-intensive in both the countries,
regardless of the differences in factor proportions and factor prices in the two
countries.
• We shall now turn to the process of factor-price equalization between the two
countries, as a result of the opening of trade between them. We will first show what
happens in the two countries, using separate graphs, and later on put them together in
Labor surplus country case
• The Box ACBD shows total factor
supplies in a labor surplus country A.
The contract curve has the shape of
ATB.
• The production isoquants X0and X1
are for good X; and Y0 and Y1 are for
good Y.
• Before trade, the country produces at
point T, where X0 is tangent to Y0 at
factor price ratio represented by the
line P0.
• At point T the capital-labor ratio in
good X is equal to , and the capital-
labor ratio in good Y is equal to.
• The size of angle TBD is more than
the size of TAC, which shows that
 Continued
• Once trade is opened, this country will go for specializing in the
production (and exports) of good X.
• This would result in a rightward shift along the contract curve
from, say, point T to point F. In moving from point T to F, there
is an increase in the production of X and a decrease in the
production of Y, which is indicated by an upward movement of
the X isoquant and a downward movement of the Y isoquant.
• In moving from point T to F, there has been an increase in the
capital-labor ratio in X production (from ) as well as Y production
(from ).
• You will, therefore, notice that in country A (a labor surplus
country) the capital-labor ratio in both goods production has
gone up after the establishment of trade.
• This is indicated by the change in the slope of factor price line
(slope of P0 < Slope of P1). This change in slope of the price line
indicates that the factor price ratio in terms of PL/PK has
increased as we move from point T to point F.
 Capital Surplus Country Case
• The box ACBD in figure 3.7 represents
factor supplies in country B, a capital
surplus country. Before trade country B
produces at point T.
• At this point, the capital-labor ratio in the
production of X was equal to the angle TAC,
and in the production of Y it was equal to
TBD.
• Trade results in specialization towards
increased production of Y (the capital
intensive good), and, therefore, the point of
production shifts from point T to, say, point
F.
 Continued
• In respect of X, the capital-labor ratio has decreased from ; and
in respect of Y; it has decreased from .

• The change in capital-labor ratios in the production of both X and

Y is indicated by the change in the slope of the relative factor-
price ratio line from P0 to P1 where slope of P0 > slope of P1.

• Thus, in the capital surplus country-country B, the capital to

labor ratio has decreased in the production of both X and Y
goods, as a result of trade.
• When this is combined with the increase in capital-labor ratio in
the production of the two goods in country A, a labor surplus
country, we eventually get to a point where the capital-labor
ratios (or factor prices) are equalized in the two countries.
 Factor price equalization: a composite graph
• Figure 3.8 is a joint of figures 3.6 and 3.7. Under
autarky, country A produced at point M and
country B at point F. The two countries' factor
price ratios were different, as measured by the
slope of the line P0 and P’0 in the two countries.

• After the establishment of trade between the two

countries, there is a shift in the equilibrium
production points.

• The equilibrium production point shifts from point

M to N in country A, and from point F to T in
country B. P1 factor price ratio line in country A (at

point N) has the same slope as the P’1 line for

country B (at point T), which shows that trade has
 Continued
• Thus, we see that international trade brings about equalization of factor
prices between countries even in the absence of factor movements
between the countries.
• It is in this sense that we argue that international trade in goods and
services, is a substitute for international movement of labor and capital.
• In other words, international trade brings about equalization of both the
product prices and the factor prices.
 Critical evaluation of the factor price equalization theorem
• The factor price equalization theorem is based on certain assumptions
which are rather unwarranted in real life. The following key points are
worth taking note of, because they constitute obstacles to the equalization
of factor prices in the real world.
1. The theorem assumes complete free trade, i.e. the absence of tariff and
non-tariff barriers to trade. It also assumes that there are no transport
costs in exporting and importing goods and services between nations
2. International trade would only lead to partial or incomplete
specialization, but by no means to complete specialization in production.
This will, therefore, rule out the possibility of complete factor price
equalization.
 Continued
3. Dualization of factor prices. This conclusion is based on the premise that
there are diminishing returns to scale conditions in the production of all goods
in all countries.

4. The theorem is based on the assumption of perfect competition and

diminishing- returns to scale in production. In the real world, however, there is
imperfect or monopolistic competition on the one hand, and on the other hand,
there are increasing returns to scale in the production of some goods. This
would destroy the credibility of the factor price equalization theorem.

5. For complete factor price equalization to take place the number of factors
should not exceed the number of products. In a model of two countries, two
factors and two goods, it is possible to show factor price equalization
6 The theorem assumes that factor supplies remain fixed in every country. This
is unrealistic, because we do know that the supplies of labor and capital keep
 Continued
7. The theorem would collapse once we show that the production
functions are not identical in all the countries taking part in
international trade. The theorem will not hold good if the factor
intensity reversal takes place, because in that event a capital rich
country and a labor rich country will export the same good by using
different techniques of production suited to their factor endowments.
Factor intensity reversal creates obstacle to factor price equalization.
 DEMAND & SUPPLY, OFFER CURVES AND THE TERMS OF TRADE
• This portion deals with how the equilibrium–relative commodity price with trade is
determined with demand and supply curves (i.e., with partial equilibrium analysis).
• Then we continue with General Equilibrium Analysis and derive the offer curves of
Nation 1 and Nation 2. We will also examine how the interaction of the offer curves of
the two nations defines the equilibrium–relative commodity price with trade. To
extend our understanding, we will examine the relationship between general and
partial equilibrium analyses. Finally, we study the meaning, measurement, and
importance of the Terms of trade

The equilibrium relative commodity price with trade- partial equilibrium

analysis
The following illustration shows how the equilibrium–relative commodity price with
trade is determined by partial equilibrium analysis, which is the study of individual
decision making units in isolation, (i.e., abstracting from all the interconnections that
Continued
 Continued
• Curves DX and SX in panels A and C or figure refer to the demand and
supply curves for commodity X of Nation 1 and Nation 2, respectively.
• The vertical axes of all three panels measure the relative commodity
price of commodity X, i.e., PX/PY or the amount of commodity Y that a
nation must give up to produce one additional unit of X.
• The horizontal axes measure the quantities of X . Panel A of the
diagram 3.4.1 shows In the absence of trade, Nation 1 produces and
consumes at point A, at the relative price of X of P1. Nation 2 produces
and consumes at point A′ at P3. With the opening of the trade, the
relative price of X will be between P1 and P3.
• At price above P1, nation 1 will produce more than it will consume of
commodity X and will export the excess production. On the other hand
at prices below P3, Nation 2 will demand a greater quantity of
commodity X than it produces domestically and will import the excess
 OFFER CURVES
• Offer curve is also referred as reciprocal demand curve. Offer curve
of a nation shows how much of its import commodity the nation
demands for it to be willing to supply various amounts of its export
commodity.
• According to this definition, offer curves incorporate elements of both
demand and supply. In other words, offer curve of a nation shows the
nation’s willingness to import and export at various relative commodity
prices.
• Offer curves can be derived easily from the nation’s production
frontier, its indifference map, and the various hypothetical relative
Derivation and Shape of the Offer Curve
of Nation 1
 Continued
• If trade takes place at PB = PX/PY = 1, Nation 1 moves to point B in
production, trades 60X for 60Y with Nation 2, and reaches point E on its
indifference curve III. This gives point E in the right panel of the diagram.

At point PF = PX/PY = ½ , Nation 1 would move from point A to point F in

production, exchange 40X for 20Y with Nation [Link] reaches point H on
indifference curve II. This gives point H on the right panel joining the points H
and E and other points similarly obtained, we generate Nation 1’s offer curve in
the right panel.
The offer curve of Nation 1 shows how much imports of commodity Y Nation 1
requires to be willing to export various quantities of commodity X.
The offer curve of Nation 1 in the right panel is above the no trade price line of
PA = ¼ and expands toward the X axis, which measures the commodity of its
 Continued
• To induce Nation 1 to exp more of commodity X, PX/PY must rise.
So, at PF = ½, Nation 1 would export 40X, and at PB = 1, it would
export 60X. There are two reasons for this
• Nation 1 incurs increasing opportunity costs in producing more of
commodity X (for export), and
i. The more of commodity Y and the less of commodity X that Nation
1 consumes with trade, the more valuable to the nation is a unit of
X at the margin compared with a unit of Y.