Factor Proportions Theory

Last Updated: March 5, 1997

Copy right 1997 by Keith Head. Do not reuse without permission.

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Recall that we are trying to explain who exports what to whom .

Adam Smith took the first shot at an answer, suggesting that I export to you the things that i'm good at making and you are poor at making.

Ricardo realized that I could be worse than you (as measured by productivity) in every activity but nevertheless I could still export to you the things that I am relatively less bad at, i.e. those things in which I have a comparative advantage. This is probably in the Top 5 Economic Insights of All Time list.

The problem with this work it is not very satisfying explanation. For instance, Canada is one of the world's largest suppliers of newsprint. Why? Well, because it has a comparative advantage in newsprint production. But why? Because relative to other nations Canada has a lower opportunity cost of devoting resources to making newsprint. But why ?

Over the next three lectures we will explore three different types of explanation for the source of comparative advantage.

Central Proposition

FPT predicts that countries will be net exporters of goods that use their relatively abundant factors intensively.

Relative supplies of general factors--Land (forest, pasture, agricultural, mineral), Labor(skilled, illiterate, scientific, artistic), and maybe Capital--Drive Trade.

tradeable commodities and services
the people and things which--when combined--create goods. Typically factors are assumed to be
  1. raw or primary ( in the sense of not being manufactured from something else)
    • electricity is not a factor.
    • the rivers which give a country the capacity to generate hydroelectric power would be.
  2. general use: part of the production process for many goods.
  3. not mobile across countries (or much less mobile than goods)
Relative Abundance
With two countries (1 and 2) and two factors (S and U), S is "relatively abundant" in country 1 if S1/U1 > S2/U2 .

In the real world there are many factors and countries so we must rely on a different rule. If your share of the WORLD'S endowment of some factor exceeds your share of the world's income then that factor is relatively abundant at home. Country 1 has relative factor abundance in S if S1/(S1+S2+S3+...) > Y1/(Y1+Y2+...).

Intensive Use
A factor is used intensively in production of a good if it accounts for a high share of the cost of producing that good.

So why do we export newsprint? Because newsprint makes intensive use of two factors "forest land" and "capital" that are relatively abundant in Canada.

So why do we export aluminum? Again, because of the relative abundance of the resources used to generate power, the most important factor in manufacturing aluminum.

Why is Hollywood the largest producer of movies? A hard core FPT-er would argue that the climate there was important in allowing movies to be shot year around, something that could not be done in most other places. The hard-core FPTer would almost certainly be missing the truth. But more on movies later.

Why do we import clothing from China? because China has a relatively abundant supply of low-skilled labour used intensively in clothing production. Note if 50% of China's work force had college degrees, they would still have an absolute abundance in low-skilled labour but they would no longer have a relative abundance.

Q. How should we think about Capital?

Capital is created by individual decisions not to consume all the income they generate, but rather to save some of it. This generates the pool of loanable funds that ultimately becomes the physical stock of plant and equipment. Capital is highly mobile, both in its financial form (mutual fund investments, bond holdings) and in "direct" form (multinational enterprises). However, studies have shown that most of what people save is invested locally. Across a sample of nations, savings rates and investment rates are highly correlated. This suggests a country's savings may indeed be seen as an "endowment" of capital.

Q. How should we think about Technology?

Economists use the term technology in a special way. In common usage, technology usually is a synonym for "applied science." A country's "endowment" of research scientists should be considered as a factor. However, economists think of technology as the methods that are used to combine factors and other inputs to create outputs. If technologies differ across countries, a worker with equivalent skills could have a substantially higher marginal product working with the same equipment in one country than another. The evidence seems quite strong that technologies do vary across countries. This is one reason why multinational enterprises exist and make profits.

Implications of FPT:

"Those with Third World skills will earn Third World wages."

Lester Thurow (MIT)

At the recent World Economic Forum, Bill Gates of Microsoft put a more positive spin on the idea, saying (approximately) "10 years from now, people won't ask you what country you are from, they will ask you how many years of education you have."

It seems likely that neither speaker realized that they were echoing the theoretical work of the most accomplished economist of the last half-century, work conducted almost 50 years ago, work whose practical relevance was dismissed as a "supreme example of non-operational theorizing" (Caves, 1960)

Samuelson's Angel

"A parable may serve the purpose of ... removing any lingering element of paradox surrounding the view that commodity mobility may be a perfect substitute for factor mobility.

Let us suppose that in the beginning all factors were perfectly mobile and nationalism hand not yet reared its ugly head. Spatial transport costs being of no importance, there would be one world price of food and clothing, one real wage, one real rent...

Now suppose that an angel came down from heaven and notified some fraction of all the labour and land units producing clothing that they were to be called Americancs, the rest to be called Europeans; and some different fraction of the food industry that henceforth they were to carry American passports. Obviously, just giving people and areas national label doen not alter anything: it does not change commodity or factore prices or production patterns.

But now turn a recording geographer loose, and what will he report? Two countries with quite different factor proportions, but with identical real wages and rents."

As the wages and employment prospects of unskilled workers declining in the first world, we naturally begin to wonder if trade barriers have fallen sufficiently that Samuelson's theory now holds true in a way that it didn't for the first 25 years after he wrote it.

Krugman responds that imports from low-wage countries represent only 2 percent of the national income, not enough to have much of an impact on American labor.

Ed Leamer of UCLA has countered that these numbers are irrelevant. He argues that the "tail can wage the dog."

"The price of labor is set on the margin...If there is so much labor available in the US that the marginal unskilled labor sews apparel, then everyone in the same regional/skill category will receive the same low wage offered in the apparel sector. It doesn't matter how many workers there are sewing apparel. It doesn't matter whether we are exporting, importing or have balanced trade in apparel. What matters is only the existence of employment in the apparel sector. If it exists, all equivalent workers are exposed to increased Chinese competition in apparel, whether they are sewing apparel or not."

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