International Trade - Theory and Policy, 2010a

3. Of points A, C1, or P1 in Figure 5.10 "Compensation in the H-O Model", this point provides
the lowest level of national welfare.
4. A type of compensation reminiscent of Robin Hood.
5. Lump-sum transfers were conceived as a way to avoid the effects of taxes or subsidies on
these decisions.
2. When a country moves to free trade, there are several ways to identify an improvement in the nation’s
welfare. One method requires information about the nation’s preferences, especially the trade-offs
between consumption of different goods; the other method does not. Explain.
5.14 Factor-Price Equalization
LEARNING OBJECTIVE
1. Understand the relationship between wages and rents across countries in the Heckscher-
Ohlin (H-O) model.
The fourth major theorem that arises out of the Heckscher-Ohlin (H-O) model is called the factor-price
equalization theorem. 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 implies that free trade will equalize the wages of workers
and the rents earned on capital throughout the world.
The theorem derives from the assumptions of the model, the most critical of which is the assumption that
the two countries share the same production technology and that markets are perfectly competitive.
In a perfectly competitive market, the return to a factor of production depends on the value of its marginal
productivity. The marginal productivity of a factor, like labor, in turn depends on the amount of labor
being used as well as the amount of capital. As the amount of labor rises in an industry, labor’s marginal
productivity falls. As the amount of capital rises, labor’s marginal productivity rises. Finally, the value of
productivity depends on the output price commanded by the good in the market.
In autarky, the two countries face different prices for the output goods. The difference in prices alone is
sufficient to cause a deviation in wages and rents between countries because it affects the marginal
productivity. However, in addition, in a variable proportions model the difference in wages and rents also
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