Factor Price Equalization

The Tendency of Convergence of Factor Prices (Prices of »Labor«, »Natural Resources« and »Capital«) in International Free Trade

An Article in the Compendium of Market-Based Social-Ecological Economics

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Key issues in view of the neoliberal crisis:
How can we guarantee employment and fair income?
How can we protect the environment effectively?
How should we shape the economic globalization?
What should the economic sciences contribute?
What must be the vital tasks of economic policy?
How can we legitimize economic policy democratically?

Click here for the list of all articles: Compendium
Click here for the German-language version: Faktorpreisausgleich

Table of Contents

  1. Abstract
  2. The Historical Roots of the Term
  3. Factor Price Equalization in Neoliberal Free Trade
  4. Impact on Labor Markets
  5. Impact on Resource Markets
  6. Impact on Capital Markets
  7. The Systemic Contradictions
  8. Economic Evaluation of the Neoliberal Free Trade
  9. Factor Price Equalization under Social-Ecological Market Economy Conditions

1. Abstract

FaktorpreisausgleichJPG01In the current free trade under the terms of the neoliberal globalization, a convergence of factor prices in US dollars – as the quasi-reserve currency – takes place, i.e. a convergence of the costs of labor, natural resources and capital. This development is historically unprecedented and is justified by proponents and beneficiaries of the neoliberal free trade on the basis that the convergence will lead to equal social and environmental standards and ultimately to equally high levels of prosperity throughout the world. However, empirical evidence shows that the current factor price equalization is directly responsible for unequal distribution, unemployment, poverty and environmental degradation (see also the article Economic Globalization).

2. The Historical Roots of the Term

In the first half of the 20th Century, the term »factor price equalization« appears for the first time, most notably in the Heckscher-Ohlin theorem and the Lerner-Samuelson theorem. These theorems were an attempt to attribute the international trade flows (the trade structure) to the diverse endowments across countries with productive factors (labor, natural resources and capital), and to declare the convergence of factor prices as mandatory under these conditions.

Said theorems are based on the assumption that labor-intensive enonomies tend to use their comparative cost advantage in labor (in terms of low wages) to export labor-intensive goods and import capital-intensive ones, given that trade in goods is free and competition is perfect, but without productive factors moving across borders. Conversely, it is assumed that capital-rich countries tend to use their comparative cost advantage in capital (in terms of lower interest rates) to export capital-intensive goods and import labor-intensive ones. It is therefore concluded that the gainful factors, i.e. labor or capital respectively, become noticeably scarce and expensive due to increased demand as a result of specialization, thus consuming the original comparative advantages and leading to a convergence of the relative factor prices (the factor price ratios) of trading partners.

If the restrictive and static assumptions of the theorems were true, international trade flows would have to dry up completely sooner or later, because all price incentives induced by comparative advantages would disappear. Many unsuccessful attempts have been made since to exemplarily outline and explain the international trade structure. None of the models was empirically supported, because the rationale behind countries’ product-specific export or import moves are multifaceted and subject to constant change under the prevailing technological progress. The extensive trade in similar products alone (the intra-industry trade), with which trading partners increase their domestic diversity in supply without being guided by comparative advantages, proves that there can be no universal and simple explanation for the international trade structure, and: that factor price equalization in free trade is not mandatory.

3. Factor Price Equalization in Neoliberal Free Trade

FaktorpreisausgleichJPG02There would be no reason to even mention the above theorems, if the term »factor price equalization« had not emerged again in the context of the neoliberal free trade – namely as »evidence« for the supposed benefits of this historically unprecedented free trade, and with the subtle promise that the world would be on its way to a single economic area with uniform social and environmental standards and equally distributed prosperity.

Today’s factor price equalization, taking place in extensively deregulated markets, and accumulating a downright destructive power – as will be seen – is characterized by the interplay between three neoliberal facts:

  1. The extreme differences (heterogeneity) between the levels of technological development and the social and environmental standards among trading partners.
  2. The inevitability in open global markets to compete on the basis of absolute price advantages, mainly to enable direct global price comparisons, with the effect that the US dollar has been »naturally« assigned the role of quasi-reserve currency. Meaning that comparative cost and price advantages will not come to fruition, because the assumptions underlying the above mentioned theorems do not apply to open global markets
  3. Global trade is dominated by unrestricted mobility of productive factors contrary to the assumptions of the above theorems. That is, apart from goods and services intended for end users, natural resources (scarce non-renewable ones and renewable ones both being produced under non-sustainable conditions) and intermediate products as well as monetary and physical capital (industrial plants, machinery, equipment, etc.) are also moved and traded across borders, and even workers are increasingly enabled in supranational and global labor markets to move freely between countries (labor migration).

For further details see the article Comparative Advantage – Upgraded.

World market prices for end and intermediate products as well as for physical capital are determined under the tough price competition in neoliberal free trade by the global interplay of supply and demand, influenced only by transportation costs and remaining trade barriers, or, more explicitly, by ultimate measures of protection which countries concerned are able to defend under the present neoliberal regime of the World Trade Organization (WTO). What countries are able to defend is in fact, with regard to sustainable economic conditions, meaningful protection, but is unaccepted and banned by the WTO as unreasonable protectionism. Due to the withdrawal of meaningful protection, countries have their productive factors exposed to repeated cycles of enormous cost pressure whenever their US dollar price levels rise above current world levels, with the locational factor and labor being particularly affected (as a complement see the article Protection and Protectionism).

As a result of price-depressive and substitution effects caused by low-priced imports, domestically oriented sectors and industries are also exposed to cost pressure. Due to the competitive pressure, incentives arise at the same time to transfer physical capital, i.e. production facilities including the associated jobs, to countries that have lower wage and price levels and accordingly promise higher returns on capital. Conversely, incentives arise to recruit professionals with export-specific skills and other workers from countries with low standards to cope with the competition-induced cost pressure by stepping up the pressure towards wages and labor costs.

It is characteristic of the factor price equalization in neoliberal free trade that prices in developed economies steadily converge to the lowest level on a global scale, while emerging economies initially catch up and are then affected by the downward spiral with delay. There is no sign of an end to this development, because the pricing, being extensively freed by national economic policy from social and environmental obligations, includes the freedom of dumping that motivates economic players to repeatedly take advantage of new scopes of cost and price reductions.

The driving force for this kind of factor price equalization is the striving for expansion (for quantitative growth) of industrial and financial players who engage in cutthroat competition in deregulated markets. Thereby generating a trend towards capital concentration, global equity links (formation of oligopolies and monopolies) and capital-intensive, purely export-oriented value creation. Standardized products are evermore produced for global markets to realize high economies of scale and scope, driving up the global trade volume at the expense of domestic production and domestic economic cycles. The trend ensures the existence of a minority of players who can provide export-oriented factors of production, while the majority of players will be crowded out in competing with low priced imports. As a compliment see the article Scale Economies and Productivity.

4. Impact on Labor Markets

An upper, export-oriented segment for employees evolves, whose range of requirements is becoming narrower and narrower and more specific due to progressing international specialization, but still holds an approximately unchanged number of jobs in Germany with attractive wages being in line with productivity developments, but also implying high workloads. There is, besides that, a shrinking middle segment with insecure jobs, and a growing lower segment with precarious wages that fall far behind productivity growth and must be bolstered by public benefits. In the middle and lower segment overqualification, underemployment and unemployment are structurally increasing at the same time.

5. Impact on Resource Markets

Roughly three resource categories can be distinguished:

  1. The politically influenceable locational factors such as land prices, taxes and legal requirements, which trend downwards in terms of prices or applicable standards due to global cost pressure, thereby accelerating the exploitation of land and soil.
  2. Those natural resources, which are not actually or supposedly scarce yet (not exploited yet), trend also downwards in terms of prices, accelerating the exploitation of minerals, air and water as well.
  3. Actually scarce resources, or those which are predictably close to their final exploitation, such as crude oil, nonferrous heavy metals and rare earths, trend upwards in terms of prices. For lack of economic regulation and control, there are no or insufficient incentives to reuse non-renewable resources in closed cycles or substitute them with renewable resources. Regarding renewable resources, there are no incentives to use them only within the scope of their natural regeneration capacity. All in all, there is a danger of inefficient use, including harmful emissions and waste, and the danger of irrevocable exploitation of these resources.

6. Impact on Capital Markets

Interest rates or returns on monetary and physical capital are again and again converging throughout the world as a result of the free movement of capital. Interest rate policies of national and supranational central banks have only small and short-term effects in the face of unregulated global capital movements. For lack of economic regulation and control, equity owners are in a position to disengage their productive physical and financial capital from its location-bound social and environmental obligations, just to flexibly engage it at the transnational level with the aim of achieving highest returns. Since such an employment of capital, being abstracted from society and environment, is not efficient and therefore not sustainable, capital markets and their stake-holders are caught up sooner or later by the damages they cause to the other factor markets.

7. The Systemic Contradictions

Measures seeking to stem the harmful effects of neoliberal free trade on productive factors prove to be counterproductive. Initiatives to stimulate economic growth, such as the reduction of corporate taxes, attract additional capital for capital-intensive export industries, where the investments usually trigger a temporary growth spurt. Macroeconomic growth rates may however even decline following such initiatives, because increased capital intensity exercises a downward pressure on labor demand and purchasing power and thus weakens the domestic economic cycles.

Education and innovation edges can here and there slow down the erosion of factor prices, but can not stop it lastingly, because the competition based on absolute price advantages enables other countries to catch up quickly. Variances in wage levels are even harmful in both directions: When falling wages are countered with increases based on collective national agreements, additional unemployment emerges, because companies respond with increased capital intensity or offshoring of jobs. When wages are prophylactically reduced to strengthen global competitiveness, additional workers become dependent on the limited and declining volume of state benefits (public transfer payments), that is, poverty deepens despite (temporarily) secured jobs.

The contradictions prove once again that a self-destructive economic system offers no possibilities to employ sustainably profitable strategies, neither for humans, nor for nature.

8. Economic Evaluation of the Neoliberal Free Trade

The development towards contemporary neoliberalism was and still is driven by corporate self-interest. The economic classification and justification of neoliberal free trade is effected ex post and built on elements of different schools of thought, in particular on the laissez-faire principle, the precedence of production and supply over consumption and demand, territorial specialization and concentration, allegedly also on the comparative advantage (see Comparative Advantage – Upgraded), and on the notion that the private economic sector would stabilize itself automatically and ensure jobs and prosperity in open global markets. And the factor price equalization constitutes arguments for an alleged confirmation of the free trade to establish uniformly beneficial world standards and to evenly distribute the produced wealth.

Contemporary neoliberalism is fully described in the articles Neoliberal Vicious Circle and Neoliberal Economic Doctrine.

In the absence of economic governance, the empirical evidence for the self-stabilization of the private sector is provided neither for national or supranational economies nor for a global economy. The neoliberal collection (usurpation) of comparative advantage as a prosperity-enhancing trading concept is obviously unjustified when competition is determined by arbitrary pricing based on absolute price advantages in US dollars or Euros.

It is undisputed that countries can increase their gross domestic product (GDP) when they are among the winners in global free trade. They must however see their profits in the light of cost pressure, specialization, and capital concentration, including the external effects caused, such as unequal distribution, unemployment, poverty and environmental damage (for more details see the article Economic Externalities). The perception that self-interest pursued without social and environmental obligations – as is the case in unregulated markets – would serve the common good, cannot be justified on economic or any other grounds.

9. Factor Price Equalization under Social-Ecological Market Economy Conditions

Sustainable international trade includes constructive international competition, which can only be implemented on the basis of bilaterally agreed exchange rates calculated to neutralize average differences in price levels between trading partners, thus allowing to identify comparative, relative (not absolute) price advantages.

When bilateral exchange rates are calculated such that they neutralize the average price-gap between trading partners – and indirectly also the productivity-gap –, an internationally competitive product can be identified by its relative price advantage and hence becomes a potential export product. In detail this means that the relative price advantage within a pair of identical or similar products being independently produced by two trading partners is identified by determining the ratios of the absolute product price to the average price of all products to be bilaterally traded (product price divided by average price), separately calculated in each national currency. The trading partner with the smallest ratio, i.e. the lowest relative product price, has a relative price advantage. Products having this advantage, as said above, are qualified as potential export products and determine the trade flows.

A trading partner who imports a product that has a relative price advantage achieves a trading profit equivalent to the difference between the (higher) domestic price and the (lower) import price, based on the agreed exchange rate. The level of profit gives an indication for both the scope of import duty and import quota to be imposed in order to constructively incorporate the imported product into domestic trade and competition with respect to market price and quantity offered. The autonomous fixing of import duties and import quotas by each and every trading partner has to be mutually conceded. In other words, with import duties and import quotas trading partners establish a mutually beneficial protection of their own economic structures, while unreasonable protectionism is prevented.

The price comparison should not, as proposed by David Ricardo 200 years ago, be based on production costs of pairs of identical products, but rather, as mentioned, on the ratios of absolute product price to average product price for pairs of identical products. This approach offers the benefit that relative price advantages and disadvantages can easily be identified even in dynamic and multi-bilateral trade relations at any time.

The articles Comparative Advantage – upgraded and Future-Proof Foreign Trade contain a detailed description of trade based on comparative, relative price advantages.

All in all, the following applies:

On the basis of comparative, relative price advantages countries can

  • engage in fair and equitable trading regardless of their stage of development,
  • mutually generate trading profits, and
  • enhance their innovation capacity and productivity in international competition.

The trade in factors of production, particularly concerning capital transfers and labor migration, must be strictly regulated and limited in order to avoid market distortions and crowding-out effects. Under the constructive and sustainable conditions described, the factor price equalization does not apply to absolute factor prices – if only because there is no reserve or key currency involved, which would allow an absolute comparison – but rather applies to the factor price ratios of trading partners. Any changes in the ratios will, by their very nature, indirectly influence the relative prices of trading products, and hence the trade flows (the trade structure). At best, these changes occur continuously and either-way, and reflect the progress in productivity effected by constructive international competition .

Click here for the German-language version: Faktorpreisausgleich

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