KALYAN CITY LIFE

Sharing Wisdom and Vivid Memories of Life

Ohlin's Factor Price Equalization Theorem with Diagram

Ohlin's Factor Price Equalization Theorem

According to Bertil Ohlin,

"Commodity movement acts as a substitute for factor movement in bringing about factor price equalisation."

In a two country model with relatively large differences in their endowments (capital and labour), prior to trade the prices of these factors will be different. With the opening of trade, each country will export the product of its abundant cheap factor. When export demand is added to domestic demand, prices of their abundant cheap factor will rise. The domestic demand for the products of scarce factors tend to decline due to the availability of such products through imports. This in turns lead to decline in the price of the scarce factor. In each country, due to the prices of the abundant factor rising and scarce factor falling the prices of both factors of production tend to move towards the same level.

Under the ideal condition of:

1. Perfect competition,
3. Identical production function,
4. No transport cost,
5. Constant returns to scale, and
6. Many other restrictive conditions.

International trade logically should result in factor price equalization.

Diagram of Factor Price Equalization

Country I produces commodity a on isoquant aa (isoquant is an equal product curve) and country II produces commodity b on isoquant bb. AB and CD are their respective factor price lines. As it can be understood from the above diagram, country I and II are capital and labour abundant respectively, hence their prices are low in respective countries.

Country I exports capital intensive 'a' commodity and imports labour intensive 'b' commodity from country II. Thus prices of capital tend to increase in country I and of labour in country II. At the same time, prices of scarce factor in both the countries fall due to declining domestic demand. With no restrictions to trade, the process continues till prices of both factors in both countries are equalised.

In above figure, the factor price line AB gradually rotates counter clockwise sliding alongwith aa isoquant. CD factor price line slowly rotates clockwise, sliding alongwith bb isoquant, until the two factor price lines (AB & CD) coincide at PL. PL is tangent to aa at T and bb at S, indicating that factor prices in both the countries are the same.

Complete factor price equalisation depends on the validity of all assumptions. The equality of factors in both countries must be the same. Factor intensity of commodities, at all prices, must remain the same (i.e. commodity a, which is capital intensive should remain the same at all set of factor prices).

In the real world, in the absence of the required assumptions and conditions, what one could experience is only the tendency towards factor price equalisation.