Capital and Natural Resource Markets

2. The Importance of Factor Prices

The prices of different factors of production can help determine which products a country will produce.

Learning Objectives

Explain how changes in resource prices affect production

Key Takeaways

Key Points

The exports of a capital -abundant country will be from capital-intensive industries, and relatively labor -abundant countries will import such goods, exporting labor intensive goods in return.
In the long-run, entities will specialize in what costs them comparatively less to produce.
If one factor of production becomes more plentiful, and therefore cheaper, it will cause production of the good that relies on that factor to increase.

Key Terms

comparative advantage: The ability of a party to produce a particular good or service at a lower margin and opportunity cost over another.

Comparative advantage is the ability of one country or region to produce a particular good or service at a lower opportunity cost than another. This idea suggests that in the long-run, entities will specialize in what costs them less to produce. These entities will then trade the goods they produce for the items that it would be expensive for them to produce. As a result, the prices of different factors of production can help dictate which products a country will choose to produce.

Trade: Trade and comparative advantage are why factor prices are so important in determining what a country produces. Trade allows a country to produce only what is comparatively cheaper for them to manufacture because they can get everything else they need through trade.

This idea was expanded upon in the Heckscher-Ohlin Model (H-O model), which was designed to be used to predict patterns of international commerce. This model is premised on several assumptions. These assumptions are:

All countries have identical production technology;
Production output is assumed to exhibit constant returns to scale;
The technologies used to produce the two commodities differ;
Factor mobility within countries;
Factor immobility between countries;
Commodity prices are the same everywhere; and
Perfect internal competition.

If these assumptions are held to be true, the HO-model suggests that the exports of a capital-abundant country will be from capital-intensive industries, and labor-abundant countries will import such goods, exporting labor intensive goods in return.

For example, a country where capital and land are abundant but labor is scarce will have comparative advantage in goods that require lots of capital and land, but little labor. If capital and land are abundant, their prices will be low. As capital and land the main factors used in the production of grain, the price of grain will also be low, and thus attractive for both local consumption and export. Labor intensive goods on the other hand will be very expensive to produce since labor is scarce and its price is high. Therefore, the country is better off importing those goods.

Shifts in Factor Prices

Assuming the cost of relative goods remain constant, if one factor of production becomes more or less expensive, it can cause a significant shift of what is produced in that country.

If one factor of production becomes more plentiful, and therefore cheaper, it will cause production of the good that relies on that factor to increase. In response to that increase, the country will produce fewer goods that rely on other factors.

For example, imagine a country has a population boom from immigration. Its supply of labor will increase. As a result, the price of labor decreases. This country produces one good that is labor intensive, clothes, and one that is capital intensive, cars. When the cost of labor decreases, the country will produce more clothes and less cars. This is not necessarily a one-to-one relationship where the production of one more shirt means one less car is produced; the only thing that can be predicted is an overall shift in production levels.

It is important to note that the shifts in factor prices described above are based entirely on the assumptions found in the H-O Model. It is rare that a real market would meet all of those standards, so the results in the real world might vary from what this section describes.