6.4: International Trade

Learning Objectives

• How does trade affect domestic prices for inputs and goods and services?

The Ricardian theory emphasizes that the relative abundance of particular factors of production determines comparative advantage in output, but there is more to the theory. When the United States exports a computer to Mexico, American labor, in the form of a physical product, has been sold abroad. When the United States exports soybeans to Japan, American land (or at least the use of American land for a time) has been exported to Japan. Similarly, when the United States buys car parts from Mexico, Mexican labor has been sold to the United States; and when Americans buy Japanese televisions, Japanese labor has been purchased. The goods that are traded internationally embody the factors of production of the producing nations, and it is useful to think of international trade as directly trading the inputs through the incorporation of inputs into products.

If the set of traded goods is broad enough, factor price equalization predicts that the value of factors of production should be equalized through trade. The United States has a lot of land, relative to Japan; but by selling agricultural goods to Japan, it is as if Japan has more land, by way of access to U.S. land. Similarly, by buying automobiles from Japan, it is as if a portion of the Japanese factories were present in the United States. With inexpensive transportation, the trade equalizes the values of factories in the United States and Japan, and also equalizes the value of agricultural land. One can reasonably think that soybeans are soybeans, wherever they are produced, and that trade in soybeans at a common price forces the costs of the factors involved in producing soybeans to be equalized across the producing nations. The purchase of soybeans by the Japanese drives up the value of American land and drives down the value of Japanese land by giving an alternative to its output, leading toward equalization of the value of the land across the nations.

Factor price equalization was first developed by Paul Samuelson (1915–) and generalized by Eli Heckscher (1879–1952) and Bertil Ohlin (1899–1979). It has powerful predictions, including the equalization of wages of equally skilled people after free trade between the United States and Mexico. Thus, free trade in physical goods should equalize the price of such items as haircuts, land, and economic consulting in Mexico City and New York City. Equalization of wages is a direct consequence of factor price equalization because labor is a factor of production. If economic consulting is cheap in Mexico, trade in goods embodying economic consulting—boring reports, perhaps—will bid up the wages in the low-wage area and reduce the quantity in the high-wage area.

An even stronger prediction of the theory is that the price of water in New Mexico should be the same as in Minnesota. If water is cheaper in Minnesota, trade in goods that heavily use water—for example, paper—will tend to bid up the value of Minnesota water while reducing the premium on scarce New Mexico water.

It is fair to say that if factor price equalization works fully in practice, it works very, very slowly. Differences in taxes, tariffs, and other distortions make it a challenge to test the theory across nations. On the other hand, within the United States, where we have full factor mobility and product mobility, we still have different factor prices—electricity is cheaper in the Pacific Northwest. Nevertheless, nations with a relative abundance of capital and skilled labor export goods that use these intensively; nations with a relative abundance of land export land-intensive goods like food; nations with a relative abundance of natural resources export these resources; and nations with an abundance of low-skilled labor export goods that make intensive use of this labor. The reduction of trade barriers between such nations works like Ann and Bob’s joint production of party platters. By specializing in the goods in which they have a comparative advantage, there is more for all.

Key Takeaways

• Goods that are traded internationally embody the factors of production of the producing nations.
• It is useful to think of international trade as directly trading the inputs through the incorporation of inputs into products.
• If the set of traded goods is broad enough, the value of factors of production should be equalized through trade. This prediction is known as factor price equalization.