Factor prices and geographical economics

A key result in neoclassical trade theory, or the Heckscher–Ohlin model, is the so-called factor price equalization theorem (FPE; see Leamer, 2012 for a survey). It states that countries engaged in free trade that produce the same set of commodities, using similar techniques, have identical factor prices. This is a surprising result if one considers that in this stylized neoclassical world, countries that differ with respect to factor supplies still have the same factor prices. This result implies that, for example, (il)legal immigrants do not affect local wages. The differences in factor supplies are absorbed by differences in the commodity bundle that a country produces. In equilibrium, a labor-abundant country produces more of the labor-intensive commodity, and the capital-abundant country more of the capital-intensive commodity. So an inflow of migrants does not lower wages because this inflow increases production of the labor-intensive commodity and thereby raises demand for labor. Consumers are not affected either because international trade corrects for the differences in local supply and demand (the excess supply of the labor-intensive commodity is traded in order to restore equilibrium). In a closed economy this outcome is not possible because an increase in labor supply and the resulting increase of the production of the labor-intensive commodity would lower its price and also wages. If this seems too good to be true, this opinion is correct. FPE is a mathematical result that has produced an enormous (empirical) literature, but, as observed by Leamer and Levinsohn (1995, p. 1357), ‘the real question isn’t whether FPE is true or not. Trust us, it isn’t true. The real question is what causes the violations we observe.’ In addition there is also no unambiguous evidence of global convergence of factor prices (Milanovic, 2005).