International Economics Topic: Factor Endowment Theory (Factor Price Equalisation theorem) Objective: This theory was contributed

by Scandinavian Economists, Professors Hecksher and Ohlin with the objective of explaining the fundamental cause of International trade. In the process of explaining this cause, theory also explains the equilibrium position of the trading countries in the global economy. Assumptions: The theory explains the above objective with the support of following assumptions: i. ii. iii. iv. v. vi. vii. viii. There are 2 countries i.e. C1 and C2. There are 2 commodities i.e. A and B There are 2 factors of production i.e. Capital K and labour L C1 is capital abundant country and C2 is labour abundant country Commodity A is capital intensive and commodity B is labour intensive There are constant returns to scale in the production of both the commodities There is perfect competition in the commodity and factor markets There is barter system of payment in both the commodity and the factor markets.

Explanation: The theory points out that the fundamental cause of trade is factor endowment difference between the trading countries. Naturally, some countries may be endowed with more of capital and some countries may be endowed with more of labour. The cost of producing capital intensive goods is relatively lower in capital abundant country while cost of producing labour intensive goods in labour abundant country is relatively lower. This is the cost difference due to factor endowment difference. Since there is cost difference, the trade becomes gainful to both the trading countries. The capital abundant country exports capital intensive goods and labour abundant country exports labour intensive goods. In this way, factor endowment difference is not only the fundamental cause of foreign trade but also it determines the direction of foreign trade. The theory explains the above factor endowment difference and the direction of foreign trade with the support of above assumptions by developing Simple Economic model of 2 countries, 2 commodities and 2 factors of production. Following is this model:

Factor endowment difference

It is represented by following Ratio differences: i. Factor Ratio difference: Since C1 is capital abundant; K is more than L and so, is relatively

higher. On the other hand, C2 is labour abundant and so, L is higher than K. It means that, is relatively lower. Therefore, factor Ratio difference is expressed as under: >

ii.

Factor Price Ratio difference: In C1, price of capital (Pk) is relatively lower than price of labour (Pl) under perfect market condition. Therefore,
1

is relatively lower. On the

other hand, in C2, price of labour (Pl) is lower than price of capital (Pk) under the condition of perfect market. Therefore, following Price Ratio difference:
1 2

is relatively higher. This summarizes

<

iii.

Commodity Price Ratio difference: In C1, price of capital intensive commodity A is lower than price of labour intensive commodity B i.e.
1

is relatively lower. In C2, price of labour

intensive commodity B is lower than price of capital intensive commodity A. Therefore,

2

is relatively higher. This summarizes following commodity price ratio difference: <

Trade and change in ratios

As the trade begins, C1 exports capital intensive commodity A and C2 exports labour intensive commodity B. This trade brings about following changes in the above ratios: I. Factor Ratio: Capital outflows from C1 in the form of export of commodity A and labour inflows in C1 in the form of commodity B. Therefore,
1

diminishes. Similarly, labour

outflows from C2 in the form of export of B and capital inflows in C2 in the form of import of A. Therefore,
2

increases.

II.

Factor Price Ratio: In C1, demand for capital increases for expanding the production of capital intensive commodity A. Therefore, under perfect competition condition, price of capital in C1 begins to rise i.e.
1

rises. Similarly, in C2, demand for labour increases to

expand production of labour intensive good B. Therefore, price of labour increases under perfect competition condition i.e. III.
2

begins to decrease.

Commodity Price Ratio: In C1, demand for commodity A increases due to expanding export market. Therefore, price of A increases i.e. for B increases, and price of B rises i.e.
2 1

begins to rise. Similarly in C2, demand

begin to decrease.

Ratio equality

The above changes in all the ratios continue until there is equality between all the ratios i.e. a. Factor Ratio equality:
1

=
1

b. Factor Price Ratio equality: c. Commodity Price Ratio equality:

=
1

As soon as the above ratio equality takes place, there is no factor endowment difference between the trading countries. Therefore, there is no cost difference. Due to this, there is no incentive to continue the trade. In other words, the trade between the countries ends as soon as the factor endowment difference is eliminated. At this point, the gains from trade for both the trading countries are maximum. Therefore, this ratio equality position is the equilibrium position of International trade between the countries.

Conclusion: On the basis of above explanation, the theory concludes that the fundamental cause of trade is natural factor endowment difference between the countries. The trading countries derive the maximum gain from trade over a long period of time, and the trade ends when the factor endowment difference eliminates in the process of trade activities between the countries. In this way, the factor endowment difference is the beginning of foreign trade and the elimination of this difference in the process of trading activity is the end of trade between the countries.

The theory also concludes that capital abundant country always exports capital intensive goods and labour abundant countries always export labour intensive goods.