The Suntory and Toyota International Centres for Economics and Related Disciplines

Factor Prices and International Trade Author(s): Abba P. Lerner Reviewed work(s): Source: Economica, New Series, Vol. 19, No. 73 (Feb., 1952), pp. 1-15 Published by: Blackwell Publishing on behalf of The London School of Economics and Political Science and The Suntory and Toyota International Centres for Economics and Related Disciplines Stable URL: http://www.jstor.org/stable/2549912 . Accessed: 15/04/2012 11:04
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FactorPrices and InternationalTrade

By ABBA P. LERNER

(The Jollowing article was prepared by ProJessor Lerner for a seminar at the London School of Economicsin December i933. It is the paper referredto by Professor Samuelson in his article, "International Factor-Price Equalisation Once Again", EconomicJournal,7une 1949, p. rI8. It is reproduced here as it was originally written; and it will be of value to studentsbothfor its place in the history of ideas and conalso for the geometrictechniqueemployedto demonstrate ditionsfor the equalisationof factor prices.)
I. Following the accepted tradition of International Trade Theory, let us make the following usual assumptions:

Factors are not allowed to move between countries. Finished commodities can move between countries without cost. (3) Perfect competition. (4) There are only two countries, two commodities and two factors. To which we add (5) The same technical knowledge is available in both
(i) (2)

countries.

From (2) and (3) it follows that the same commodities must have the same price in both countries (all prices being converted on to a common basis at the current rate of exchange) and also the same cost of production wherever they are produced. A first glance at these considerationswould seem to suggest that there must be complete specialisation in at least one of the commodities unless factor prices are the same in both countries. For if in equilibriumone factor is cheaper in one country than in the other, the other factor must be dearer or else the first country would export both commodities and this import neither. Fronm it would follow that the commodity which used a larger proportion of the cheaper factor would

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have a lower cost in this country than in the other so that the conditions of equilibriumwould be upset by any difference of factor prices as between the two countries. 2. This seems to fit in with the generalview that divergent scarcities of factor are the moving forces behind international trade. In lieu of the export of factors which are unable to move, there are exported commodities which contain the services of cheaper factors in a greater proportion than the commodities which are imported. This movement extends until either (a) complete specialisation has already been reached, i.e. there is no commodity being produced abroad which contains a greater proportion of this cheaper factor than .any commodity produced at home, or (b) the price of the cheaper factor has risen to equality with its price abroad. Therefore, if both commodities are produced in both countries,the equilibriummust be of the second type, i.e. factor prices must be the same in bothcountries. 3. Against this it is often objected that it is impossible for factor prices to be the same if the ratio between total quantities of the factors is different in the two countries. For if factor prices are the same, the proportion in which factors are combined in the production of commodities must be the same, so that some of the factors would remain unemployed and so change the price. This argument is based upon a confusion between two ratios: the ratio between the factors in the production of a particular commodity, and the ratio between the quantities of factors in a country. There is no need whatever for these to be the same. The larger proportion of a factor in one country can be taken up in the production of the commodity which uses a larger proportion of this factor, if this commodity is produced in a greater proportion to the other commodities in this country than in the other country. Thus if in countries I and 2, commodities A and B are made from factors X and Y, if the factor prices are the same in both countries, the factors will be combined in the same proportion in both countries for the production of each commodity. Suppose one unit of X and one unit of Y a combine to mnake unit of A, and one unit of X and 5 units of Y combine to male a unit of B. Then the proportions between the factors in each country can be anything between I: I and I: 5. If in country I there are ioo X and 2oo Y

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and upon the desire to trade by the other country (which depends upon both the technical conditions in the other country and upon conditions of demand there). This curve shows what possible ratios of factors in the production of any commodity are compatible with the existing ratio of factors in the country. 4. The argument given in sections (i) and (2) is not sufficiently rigid and certain limitations have to be imposed upon the propositions enumerated. It will, however, be found to provide a substantially reliable rough expression of the correct theory. If A and B are the prices of the commodities, X and Y the prices of the factors, K and L the respective quantities of X and Y used in the production of a unit of A, M and N the quantities used in the production of a unit of B and the subscripts i and 2 indicate to which country the prices or quantities refer, we can express the conditions of equilibrium in the equations: A1= K Xi+ LI Y== ]K2 X2+ L2 Y2-=A2
B1=- M1 X1+ N, Y,== M2 X2+ N2 Y2== B2

These equations are satisfied if factor prices are the same in both countries, for in that case the proportion of the factors used in each commodity must be the same in both countries, all the subscripts disappear and the equations become identities. 5. Contrary, however, to what seems to be implied in the simple reasoningof section (i) this is not the only solution. There are possible two other types of solution, but these depend upon such unlikely conditions that they may fairly be said to be of theoretical rather than practical interest even when comparing them with the abstract theoretical problem which we have so far discussed. The first of these two " theoretical " solutions' refers to the case where the ratios of the factors are the same in each country for both commodities. It is then possible for factor prices to be different in the two countries, one factor cheaper in one country and the other factor cheaper in the other country, while the argument of section (i) could not be applied as there is no commodity " which uses a larger proportion" of any factor. Against the objection that in
I Suggested to me by Mrs. J. Robinson

of Cambridge,

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this case the two commodities are economically "one commodity " the view was held that this identity of factor proportions need not be true for all price relationships, but only for those reached in the equilibriumposition. It can be shown that these conditions are not sufficient to assure equilibrium. If - _ I and K,=M' it is still possible L2 N2 L, N1 to have the case indicated by the equations ( A1= zX1 + 3Y15X2 + Y2zY A2
B1=4X1

+ 6Y1=15X2

+ 6Y2= B2 f

(z)

where the coefficients of production, K, L, M and N of equations (i) are replaced by figures which satisfy the conditions of equal ratios of factors for both commodities in each country as well as the general condition of a positive and finite elasticity of substitution. It is obvious that both of these equations cannot be true whatever the prices of the factors. Unless factor prices are the same in both countries (in which case K, L, M and N would have to be the same too) it is necessary that would follow, that L,
-_2

and also, which

This is only likely to be the

case if the technical conditions of production of the two commodities are identical over a considerablerange, so that, economically, they are one commodity. 6. The second " theoretical solution " is indicated by the followingvalues of the terms in equations (I). X1 Y, K, L1 M, N, X2 Y2 K2 L2 M2 N. 10 3 3 i6 2 20 7 5 4 10 5 9 Substituting these in thLe equations we get A1-(3 x Io) + (I6 X 3) (4 x 7) +(IO X 5)- A, - 781 X IO) + (20X 3) =(5 x 7) +(9 x 5) = B2-8o ( Bl=(2 Here neither factor prices nor proportions of factors are the same, yet the equations are satisfied. This case definitely shows the simple argumentof section I to be erroneous. The special condition under which such solution ma\v be possible will be best showNnbyt a diagrammatical treatment of the problem.

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7. Fig. 2 shows two isoquants, A and B, for unit quantities of the two commodities. By our assumption of equal technical knowledge they are applicable to both countries.

a, Fig. 2

b,

a2

b2

Let a pair of parallel tangents be drawn to the two isoquants at A1 and B1 to cut the X axis in a. and b, and another pair of parallel tangents at A2 and B2 to cut the X axis in a. and b2. The slope of the first pair of parallel tangents representsthe price ratio of the factors in country i, and the slope of the second pair of tangents represents the price ratio of the factors in country 2. All combinations of factors indicated by the co-ordinates of points on a tangent will have the same total value at the price ratio indicated by the slope of the tangent. Factors vill be used in the proportions indicated by the co-ordinates of the point where these tangents touch the isoquants, for these are the points where, at the given factor-price ratio, any expenditure on output of the commodity. In factors gives a miiaximum i the quantities of factors per unit of commodity country will be measured by the co-ordinates of A1 and B1 and in country 2 the! wviiibe measured by the co-ordinates of A2
and B2.

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Since the value of a unit of a commodity is equal to the value of the factors it incorporates, and since all points on a tangent represent the same value, the value in country i of a unit quantity of A will be equal to the value of a, of factor X, and a unit of B will be equal in value to b, of factor X. In country 2 commodities A and B will be worth a2 and b2 respectively in terms of factor X. The conditions of equilibrium, that relative commodity prices are the same in both countries, can then be represented by the formula
a,_
a2 b2

b,

8. If factor prices are the same in both countries, this condition is satisfied for curves of any shape and for all factor-price relationships, for the two pairs of parallel lines coincide and become one pair of parallel lines, a1 a2 and b == b2, 9. Equilibrium may be reached with factor prices different in the two countries if the proportions in which the factors are used are the same for both commodities in each country but not the same in both countries. This is Mrs. Robinson's case and is shown in Fig. 3. It can also be easily seen that
Yj

O,

3
F ig. 3

.,b

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these conditions are not sufficient for the equilibrium to be reached, for, by similar triangles, aL a, onlv if OA, OA2 The meaning of this and the likelihood of its happening will relationships between the isoquants of the different commodities.
IO. Of all possible relationships between the shapes of the isoquants for the two commodities, the most likely case seems to be that in which one commodity will use a relatively larger proportion of one of the factors, whatever the relative prices of the factors in the country. If B is the commodity which at all factor-price ratios uses a relatively largerproportionof X, this will be shown by the twvo different isoquants being so shaped that if two parallel tangents are drawn to them at A1 and B1 in Fig. 4, OA1 will be steeper
y A
B

bJF2

0B,

0B2

be investigated below when we come to analyse possible

A,~~~~~~~
A3~~~~

~~~~~~~~~~~~~~1
bi Fig. 4

~~~~~~~0X
b2

than OB1,whatever the slope chosen for the parallel tangents. From this it follows that if any line from the origin cuts both A and B, say at Al and B., the tangent at B2 will be

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We shall then have two lines each touching the two same isoquants and this is necessary for equilibrium. But in Fig. 4 it is impossible to draw two lines each of which touches both A and B. Only one line can do this-the one touching them at A3 and B3. Full equilibrium with curves of this form can therefore only take place if the prices of the factors are the same in both countries.
A2a2. i i. If a pair of curves A and B cut in two places (C and D in Fig. 5), one curve must be more convex than the other.
Y
AB

B~~B

L~~~~~~~~

0
b, b2
2

~~~~~~~~~~~~
Fig. 5

The elasticity of substitution of the factors in the production of one commodity must be so much greater than for the other commodity that somewhere between C and D the isoquants A and B are parallel for the same ratio between the quantities of factors used. At K and at L and all along OS, A and B curves are tangential to each other. The relative quantity of X for any factor-price ratio is greater for B than for A above OS and smaller below OS. Every tangent to both an A and a B curve must touch both either on the samne side of OS or on OS,

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In the former case one other tangent can touch the same two isoquants on the otherside of OS. The factor-quantity ratios as between the two commodities will be reversed in the two countries. The same commodity (A) will be able on account of its greater elasticity of substitution to use relatively more in each country of that factor which is cheaper in that country, and thus maintain the same price relationship to the other commodity. This is the state of the arithmetical solution in section (6). It will be possible, however, at only one factor-pricerelationshipin each country for any factor-price relationship in the other country. This will be at the point where the change in the proportion of the factors used just balancesthe differencesin factor prices as between the two countries. This solution is clearlIN possible only as an unlikely coincidence. I2. The case where two curves A and B cut each other in three places is shown in Fig. 6 where they cut at C, D and E.
YA A 1B

B'~~~~~~B

B2~~~~~~~~~~

0
bi Fig. 6 b2

~~~~~~~~~~~~

three different lines each of It will here be possible to draNw which touches both A and B, each line representinga different possible factor-price ratio in a different country, all three

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13

countries being in international trade equilibrium. There will also now be two lines radiating from the origin, OS and OT, along which A and B curves touch each other. The points of tangency of any line with the curves A and B will be either bothabove OS, in which case B1 will be below OS A1, or both betwveen and OT, when B2 will be aboveA2, or else bothbelow OT, when B3 will be again below A3. In comparing country i with country 2 and in comparing have exactly the same country 2 with country 3 in Fig. 6, wve described in the section (iI). But in comparing case as that coulntry i with country 3 we have a new% phenomenon. In country I factor X is dear and in country 3 X is cheap. In both countries commodity B uses relatively more of X as comparedwith commodityA. Yet prices of both commodities are equally affected by the change in the price of the factors. This is because the gain of the commodity (B) which uses a larger proportion of the cheapened factor (X) in virtue of the saving in the cost of the quantity initially used is offset by the loss due to its not being able to increase its proportion of the cheapened factor in as great a ratio as the other commodity (A) which uses a smaller proportion of this factor. This solution, too, can be seen to be a very unlikely case as again for any factor-priceratio in country i there is only one correspondingfactor-price ratio in country 3 where the counterposed forces are just equal and an equilibrium is attained. There appears to be no mechanism whereby such a position would be approached so that it must be considered as an unlikely accidental solution that would be immediately upset by any change in data if indeed it ever happened to be hit upon. 13. A tangent to both curves at the same point, whicl would have to be on a line of the type of OS or OT, would show a special kind of equilibrium, having some of the qualities of all the different types considered, and therefore also partaking of the attribute of stability. It would shows Inotonly the same factor prices in both countries, which is a but sufficient condition for stable equilibriumn, also the ratio of factors the same for both commodities, not only in each country but, which would follow from this and from the equality of factor prices, in both countries.
14. It is not necessary to go on to consider curves whicih cut more than three times. It can be seen that curves which

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cut n times have n possible common tangents and n-I "radiants of tangency" as OS and OT may be called. The more often curves cut, the more alike they must be in shape, and we may say that the more often they cut, the closer they approach identity of shape. Curves may be expected to be identical rather than cut many times. The likelihood of a solution of the type illustrated in Fig. 3 can be indicated by considerations of this kind. We have seen above (section (IO) ) that in any equilibrium in which factor prices are different in the two countries, two common tangents can be drawn to the two curves. This means that, in Fig. 3, another B curve, say B1, touches both Ala, and A2a2. Since all our curves represent homogeneous fuinctions, and A and B liave parallel tan-gents (- equal slope) at A2 and at B,, A and B curves must touch each
other along OB2. Similarly, they must touch each other ailong OA2. B1 will therefore touch Ala, and A2a2 at the same points where these are touched by A, namely at A, -andA2. This is shown in Fig. 7. OS and OU are "radiants of tangency ", and there must be another "radiant of
y
A

'B~~~~~~~~~~~~

Ab

b7

Fig. 7

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tangency " between these (unless the curves are identical throughout in which case these cover the whole surface) and it is here shown in OT. TFhree" radiants of tangency " must mean curves cutting four times. This is seen to be the case, for the B curve immediately below B' must cut A in four places, once on each side of A1 and A2. We see then that the equilibrium of F'ig. 3 demands isoquants wzhich cut four timcs wN-ithout becoming identical. But this is not all. If we consider the B curve immediately above the one drawn w-e shall see that it does not cut A at all. This means that not only must there be B curves which cut A on A curve four times, but that any B curve wlhich does not cut A four times must not cut it at all. Either four or none. Only if this is the case will any B curve touch an A curve
twice.

Further, coincidence is necessary for this equilibrium even if we are given isoquants of this form. There are only two factor-price ratios in any country which make this equilibrium possible and if one of these is reached the equilibrium is not possible unless the factor-price ratio in the other country is the other of this pair of factor-price ratios which are shown in the two tangents in Fig. 7. From all this we may conclude that if two (or more) commodities are produced in each of t\o (or more) countries, between which commodities can move and in which the same technical knowledge is available, then in any stable or reasonably likely equilibrium physically similar factors,' even though they may not move between the countries, will have the same price in each country. Roosevelt College, Chicago, 5.