Unit 2: Why Trade?
Part 5: A Modern
Day Interpretation: The Factor-Price Equalization Theorem
When we say that nations should specialize in one good over
another, however, we don’t mean that they should produce
only that good. Rather, there is a kind of window of specialization
that proves efficient for each country and the world in
general. According to more recent work in trade theory,
such as that by Paul Samuelson, this window is largely dependent
on the relative prices of the factors of production—land,
labor, and capital—in different locales. And the prices
of these factors of production are largely determined by
their availability and use.
WEBSITE: For a bio of Paul Samuelson,
check out:
http://www.econlib.org/library/Enc/bios/samuelson.html
US computers vs. Mexican t-shirts. For
example, suppose initially that the US can produce two computers
or 200 hundred t-shirts in one hour, and Mexico can produce
one computer or 150 t-shirts in an hour. Then the US has
an absolute advantage in everything and a comparative advantage
in producing computers (one computer costs only 100 t-shirts
in the US, while one computer costs 150 t-shirts in Mexico).
So the US should specialize in computers and Mexico in t-shirts.
However, they will only specialize in each of these
goods so long as they continue to have lower relative costs,
which are subject to change as each nation’s production
of computers and t-shirts changes. The reason for this is
quite simple: the price of a computer or a t-shirt is determined
largely by the cost of the land, labor, and capital that
was used to make it; and the cost of that land, labor, and
capital is determined by its initial scarcity and its use.
Since Mexico has a relative abundance of lower skilled workers
compared to the US, such workers will be paid lower wages
in Mexico. And if producing t-shirts requires lower skilled
workers, then t-shirts will cost less in Mexico too.
Diamond-water paradox. The logic of this
argument is essentially the same as the famous diamond-water
paradox: how can diamonds be more expensive than water when
they are an unnecessary luxury and water is necessary to
sustain your life? It’s all about their relative scarcity.
Now, let’s suppose that Mexico and the US begin to
trade. What will happen to Mexico’s t-shirt prices
if they begin to specialize in t-shirts? They will go up.
Why? Because as Mexico produces more and more t-shirts,
this will increase their need for lower skilled workers—making
them more scarce (and more expensive). At the same time,
as the US specializes in computers (which require higher
skilled workers), the demand for lower skilled workers will
go down and their wages will fall.
This implies that when nations begin to trade, it puts pressure
on wages for similar skills (and prices of similar goods)
to equalize around the world. This theory of wage (price)
equalization goes a long way toward explaining why labor
unions in the US comprised of workers with lower levels
of education are likely to lobby very hard against trade
liberalization. Sure, their t-shirts might be cheaper, but
those cheap t-shirt might cost them a lot more in lower
wages. On the other hand, as the US specializes in computers,
the demand for skilled workers with advanced training will
go up, resulting in higher wages for them, and of course,
cheaper t-shirts as well. One criticism of free trade in
America that this theory supports is that even though trade
may increase living standards on “average,”
its relative effects are disproportional, resulting in a
widening income gap between those with technically advanced
skills and those without.
VIDEO: Impact
of Specialization on Wages in the US and Mexico
VIDEO: Levi’s
Factor Price Equalization Story
WEBSITE: For an additional summary on the
effects of free trade on prices, wages and jobs, please
read the article “Free Trade” by Alan S. Blinder
of Princeton University:
Free Trade
http://www.econlib.org/library/Enc/FreeTrade.html
