Factor price equalization

Factor price equalization is an economic theory, by Paul A. Samuelson (1948), which states that the prices of identical factors of production, such as the wage rate, or the rent of capital, will be equalized across countries as a result of international trade in commodities. The theorem assumes that there are two goods and two factors of production, for example capital and labour. Other key assumptions of the theorem are that each country faces the same commodity prices, because of free trade in commodities, uses the same technology for production, and produces both goods. Crucially these assumptions result in factor prices being equalized across countries without the need for factor mobility, such as migration of labor or capital flows.

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.^[1]

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 input 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.^[2] The "Lerner Diagram" remains a key analytical tool in teaching international trade theory.

See also

• List of international trade topics

References