Art Carden  

By Request: Factor Price Equalization

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From Paul Ralley:

Please can you describe a plausible 'end game' for price-factor equalisation. I.e. If incomes in each country converge (per skill level) what would the world look like in terms of trade, income distribution etc.

I'm not sure what this end game would look like. If he's asking about an equilibrium in which labor and capital are mobile across borders, then I suspect labor and capital will move toward the regions with the best institutions. This in turn, though, would provide powerful incentives for countries to reform: in order to prevent almost everyone from moving to the United States and Europe, a lot of countries would have to cut taxes and improve provision of basic public services.

In the long run, we would all be richer. In the short run, there would be a lot of disruption. Some of the gains to migrants would come at the expense of high- and low-skill natives. I'm pretty sure the change would be Kaldor-Hicks efficient in that the gains to the winners would be larger than the losses to the losers. Given that high- and low-skill workers are earning an economic rent emerging from barriers to entry into the American labor market, I don't think taxing the winners to compensate the losers would be justified.

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COMMENTS (4 to date)
Jacob A. Geller writes:

In the short run, labor and capital would move less as factor prices converge, to the extent that the current labor and capital flows are motivated by factor price differences.

It doesn't appear that capital, however, flows to where it is scarce/expensive, however, (Africa, namely) rather it has flowed to where capital was already abundant and cheap (the developed world), suggesting that factor prices haven't been the main drivers of international capital flows.

Labor however does appear to flow (or at least *wants* to flow) to places where labor is scarce (e.g. from India, to the U.S.), so maybe in a world with converging incomes, migration (or the desire to migrate) would become less common.

In the long run I would tend to think that in such a world, the quality of institutions would be converging too, because that's what (given geography) I think tends to drive long term income changes (and therefore convergence).

Picture Narendra Modi doing a fantastic job as prime minister of India, and most African nations adopting more modern/democratic institutional norms, and people getting richer in developing countries in general, and fewer and fewer migrants wanting to move from those countries to the developed world, and immigration reform ceasing to become as critical an issue, and a reversal of the current norm of (contra theory) capital flowing from China to the U.S., I.e. theory starting to "become correct" as cities like Nairobi and Delhi become like New York and Los Angeles, and bankers getting very rich off of all the money that is to be made in investing in emerging markets, and that is basically what I picture a factor price equalization "end game" looking like. I consider that not only plausible, but likely.

Tom writes:

Not sure I follow your logic here ... improve public services while lowering its funding? I know there are inefficiencies in many institutions, but many are underfunded as they are (highway infrastructure is a classic example in many parts of America)

Nathan W writes:

Can workers move to where their skills can most productively be paired with other inputs, or is it only permitted for capital to flow to wherever it can earn the highest profits when combined with labour inputs which are not allowed to move?

You could set up a theoretical structure where the result will be the same either way, but presumably a world where capital can move freely and labour cannot could anticipate that capital holders will exert influences on market dynamics which would lead far different outcomes from the situation of both labour and capital mobility.

How is it, in a "free" world, that money can move and people cannot?

Paul Ralley writes:

Art - many thanks for this, and all your postings. Paul

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