Price Equalization Theory

OWOYOMI OLUWATOSIN ADEDAPO
1/16/2013
| ECONOMICS AND STATISTICS | AN ESSAY OF THE EVALUATION OF FACTOR PRICE EQUALIZATION THEORY. | MAT NO: SSC0905121 |

INTRODUCTION
Factor price equalization is an economic theory, by Paul A. Samuelson (1948), which states that the prices of identical factors of production, such as the wage rate, or the return to capital, will be equalized across countries as a result of international trade in commodities. The theorem assumes that there are two goods and two factors of production, for example capital and labour. Other key assumptions of the theorem are that each country faces the same commodity prices, because of free trade in commodities, uses the same technology for production, and produces both goods. Crucially these assumptions result in factor prices being equalized across countries without the need for factor mobility, such as migration of labour or capital flows.
Whichever factor receives the lowest price before two countries integrate economically and effectively become one market will therefore tend to become more expensive relative to other factors in the economy, while those with the highest price will tend to become cheaper.
Economic theory suggests two powerful mechanisms promoting factor price convergence across regions and countries — goods trade and factor mobility. Within a country, goods markets are more highly integrated, and factors of production are more mobile, than they are across countries. As a result, factor price equalization, to the extent it exists anywhere, is more likely to occur within nations than internationally Absolute factor price equality implies that identical factors of production are paid the same wage across regions. Relative factor price equality, on the other hand, allows absolute wages to vary so long as relative wages (i.e. the skill premium) remain constant. An obvious potential explanation for a violation in absolute factor price equality is the existence of regional Hicks-neutral productivity differences: regions with higher Hicks-neutral Productivity can offer higher wages to both skilled and unskilled workers even while relative wages remain uniform. Rejection of factor price equality can also arise for more complicated reasons. For example, both absolute and relative factor price equality can fail due to unobserved variation in regional factor quality.

LITERATURE REVIEW.

Analyzing the effect of such variation on output and wages has a long history in the international trade literature, including the classic paper by Leontief (1953) and the more recent cross-country study by Trefler (1993). A key advantage of the methodology that we develop is its robustness to unobserved differences in factor quality. Indeed, our tests control for factor quality differences across pairs of regions and industries.

Our approach is based upon extremely general conditions for producer equilibrium and builds upon techniques developed by Bernard and Schott (2001) to test for factor price equality in the US. We generalize that theoretical framework from the case of the CES production technology to any constant returns to scale technology, to allow for unobserved factor quality differences that are region-industry specific rather than just region-specific, and to the case of imperfect competition. Our methodology exploits the fact that, although an empirical researcher will not typically observe factor quality or quality-adjusted factor prices, observed factor prices contain information about the quality of observed factors when firms minimize costs. This approach does not make any assumptions regarding the preferences and costs of living faced by different types of workers. As a result, it is robust to unobserved variation in consumer price indices specific to types of workers or locations. Nonetheless, the analysis has implications for the value of real wages and the degree of factor mobility across locations. Though our technique is applicable to any number of factors of production, we focus here on the wages of skilled versus unskilled labour. We find strong evidence against both absolute and relative factor price equality in the UK. This rejection exists across both coarsely-aggregated Administrative Regions and much more finely-defined Postcode Areas, which approximate local labour markets. Estimated differences in quality-adjusted factor prices across the UK are highly statistically significant and quantitatively important. We explore a number of potential explanations for deviations from factor price equality. One subset of explanations provide intuition for the failure of factor price equality. Among these are the existence of multiple Heckscher-Ohlin cones of diversification within the UK and several aspects of the new economic geography. We also consider how data-related issues can induce a rejection of the null hypothesis. In each case, we highlight additional empirical implications which can be pursued. Existing tests of factor price equality, including Cunat (2001), Debaere and Demiroglu (1997), Repetto and Ventura (1998), and Schott (2001a, 2001b), have focused on the variation of wages across countries or the existence of multiple cones of diversification in international production data. Other studies, including Davis et al. (1997), Bernstein and Weinstein (2002) and Hanson and Slaughter (2002), have looked for evidence of factor price equalization across either Japanese prefectures or US states. Further research on the spatial variation of productivity and factor prices in the United States includes Ciccone and Hall (1996), Ciccone (2001), and Hanson (1998). Muellbauer (2000,2001), Duranton and Monastiriotis (2001), Gosling et al. (1996), HM Treasury (2001), and Machin (1996) has examined the extent of regional earnings and productivity differences across regions. Haskel and Slaughter (2001) analyze the impact of international trade on wage inequality at the level of the United Kingdom as a whole. Though some of this research has found evidence consistent with a violation of factor price equality, none of the studies has controlled for the sort of variation in factor quality and technology differences that we find so important. Our study is also the first to examine the finely defined UK Postcodes in addition to the coarsely aggregated Administrative Regions.

THEORETICAL LITERATURE.

Production

We consider a very general specification of the production environment facing firms that allows for both perfect competition and imperfect competition, as well as variation in goods prices, technology, and factor quality across regions and industries. Regions are denoted by r, industries by j, and time by t. Throughout the exposition, subscripts are used to refer to industries or regions and superscripts to refer to factors of production or pairs of factors. In each industry-region, firms choose output and employment of factors of production to maximize profits subject to a constant return to scale production technology,

Πrj = vrj(Yrj)Yrj − wPr Prj − wNr Nrj – wKr Krj (1)

Yrj = Arj Fj(Prj, Nrj, Krj) (2)

Where v is the output price, P is employment of quality-adjusted production workers, N is employment of quality-adjusted non-production workers, and K is employment of quality-adjusted physical capital. The factor prices wPR , WNR and wKR are per quality-adjusted unit of a factor of production. In this specification, firms may either act as price-takers in product markets (perfect competition) or choose prices subject to a downward sloping demand curve (imperfect competition). They behave as price-takers in factor markets. Although the main exposition here assumes constant returns to scale, later sections and an appendix introduce increasing returns to scale and discuss their implications for absolute and relative factor prices.

Quality-adjusted and Observed Factors.

If it were possible to observe quality-adjusted factor prices and quantities in the data, we could test for factor price equalization directly. In practice, factor quality is not observed and we allow it to vary in a completely general way across both regions and industries. Quality-adjusted employments of factors of production will be related to their observed values as follows,

Prj = θPrj˜ Prj, Nrj = θNrj˜Nrj, Krj = θKrj˜Krj . (3)

Where a tilde above a variable indicates that it is an observed value. Observed factor prices will be related to quality-adjusted values according to,

˜ wPrj = θPrjwPr , ˜ wNrj = θNrjwNr , ˜ wKrj = θKrjwKr . (4)

Cost Minimization

Our tests for factor price equality are direct implications of firms’ cost minimization (hence the property that they hold under both perfect and imperfect competition). The cost function dual associated with the production technology is,

Brj = A−1rj Tj (wPr , wNr , wKr )Yrj . (5)

Demands for quality-adjusted factors of production may be obtained using Shepherd’s Lemma,

Prj = A−1rj Yrj∂Γj(·)/∂wPr, Nrj = A−1rj Yrj∂Γj(·)/∂wNr, Krj = A−1rj Yrj∂Γj(·)/
∂wKr . (6)

Dividing one first-order condition by another, we arrive at an expression for relative demand for any two quality-adjusted factors of production. Thus, for non-production (skilled) and production (unskilled) workers we have,

Nrj /Prj = ∂Γj(·)/∂wNr∂Γj(·)/∂wPr. (7)

Using the relationship between quality-adjusted and observed values in (3), this implies the following relative demand for observed factors of production,

˜Nrj˜ Prj=θPrjθNrj∂Γj(·)/∂wNr∂Γj(·)/∂wPr . (8)

Regional Factor Price Differences

In principle, the price of each quality-adjusted factor of production may vary across regions. To capture this variation, we make use of the fact that any factor price difference between a region r and another reference regions can be decomposed into a component common to all factors of production (λrs) and a factor-specific component (γz rs, z ∈ {P, N, K}). For example, wNr = δNrswN s = λrsγNrswNs (9) wPr = δPrswPs = λrsγPrswPs wKr = δKrswKs = λrswKs

Where, in the example above, we have normalized the common component using capital price differences across regions (λrs = δK rs and γNrs = δNrs/δKrs). Other normalizations are clearly possible and the analysis is invariant to which is chosen. Since it is hard to accurately measure the real user cost of capital at the regional level, we focus in our empirical work on the absolute and relative wages of non-production and production workers. Under the null hypothesis of factor price equalization, all factor prices are equalized. A rejection of relative factor price equalization for any pair of factors will therefore be sufficient for a rejection of the null hypothesis. In principle, the analysis here may be undertaken for all combinations of factors of production.

Relative Factor Price Equalization (RFPE)
Null Hypothesis

Our most general test of factor price equalization is concerned with relative factor prices, and allows for both unobserved variation in factor quality across region-industry pairs and neutral technology differences. The null hypothesis of Relative Factor Price Equalization (RFPE) may be formalized as:

(H0 : RFPE), γzrs = 1 ∀ z,wNrwPr=wNswPs. (10)

The potential existence of unobserved factor quality differences across regions within an industry (θNrj 6= θNsj and/or θrj 6= θPsj in equation 4) means that we cannot test this hypothesis directly using observed relative wages. However, we show below that RFPE implies the equalization of observed relative wage bills across regions and that this prediction is robust to unobserved factor quality differences. Without loss of generality, we choose region s as the reference region for measuring factor quality differences so that,

θNsj = 1, θPsj = 1, ∀ j. (11)

Under the null hypothesis of RFPE, the values of observed relative wages in the two regions are given by,

˜ wN r˜ wPr=θNrjθPrj˜ wNs˜ wPs. (12)

Observed values of relative employment in the two regions may be obtained using equation (8). Under RFPE, quality-adjusted factor prices differ across regions by a component λrs that is common across all factor prices. Homogeneity of degree 1 of the cost function implies that the derivatives ∂Γj /∂wzr are homogenous of degree 0 in factor prices.

EMPIRICAL LITERATURE

Baseline Specification

We first report the results for Administrative Regions, followed by those for Postcode Areas. Table 2 reports the estimated differences in log relative wage bill ratios for Administrative Regions in 1992 and 1986. In 1992 at the 5% significance level, we find one rejection above zero (for the South-East of England) and 5 rejections below zero (for the East Midlands, Yorkshire & Humberside, Northern, Wales, and Scotland). The results for 1986 display a similar pattern. At the 5% significance level, we again find a rejection above zero for the South-East of England, and there are again 5 rejections below zero, with the West Midlands replacing the East Midlands. Whether a positive estimated value of the dummies corresponds to a higher or lower quality-adjusted relative wage of skilled workers depends on the operator TJ in the cost function (equation 18).

With a CES production technology, a positive coefficient corresponds to a lower quality-adjusted relative skilled wage under a CES production technology if 0 < ρ < 1 (see equation 20). These values of ρ imply an elasticity of substitution between skilled and unskilled workers greater than unity (i.e. σ > 1), which is consistent with typical empirical estimates in the labour literature (see in particular Katz and Autor 1999 and Katz and Murphy 1992). Table 3 reports implied quality-adjusted relative skilled wages for σ = 2. We find that the skilled-abundant region (here the South-East) is characterized by a lower equilibrium value of the relative wage of skilled workers The actual wage of non-production workers relative to production workers in the South-East was 97% of the UK value in 1992 and 99% in 1986. In both years, this is higher than the estimated quality-adjusted relative wage for σ = 2. This therefore suggests that the relative quality of nonproduction workers in the South-East is higher than in the UK as a whole, as is consistent with economic priors. Results for Postcode Areas in 1992 and 1986 are presented in Tables 4 and 5. As indicated in the tables, 32 of 111 regions reject factor price equality at the 10% level in 1992. Of these, 9 reject above zero and 23 reject below zero. Table 4 reports the estimated dummies for those Postcode Areas that reject above zero. These are concentrated exclusively in the South-East of England close to the M25, M4 corridor, and the area around Cambridge; they include Cambridge, St. Albans, Reading, and Slough (see Figure 3). Results for 1986 display a similar pattern: 34 regions reject factor price equality at the 10% level of significance, with 7 rejecting above zero and 27 rejecting below zero. Four of the rejections above zero are the same Postcode Areas as in 1992: Hemel Hempstead, Reading, Slough, and Sutton. The emergence of Cambridge and St. Albans as high relative wage bill regions is specific to 1992 and is consistent with the recent development of a cluster of skill intensive information technology and biotechnology industries in this area.

Tables 4 and 5 also report implied quality adjusted relative wages for σ = 2. Figures 2 and 3 displays the geographical distribution of the estimated coefficients for Administrative Regions and Postcode Areas respectively in 1992. The figures separate three groups of regions - those with positive and statistically estimated values of the dummies (indicated by the dark shading); those with negative and statistically significant estimated values of the dummies (corresponding to the intermediate shading); and those with statistically insignificant estimated values of the dummies (light or no shading). Both figures show a clear concentration of regions with positive estimated values of the dummies in the South-East of England where, for σ > 1, the (quality-adjusted) skill premium is relatively low. We also allow each Administrative Region and each Postcode Area to serve as the base and then run the bilateral regression specified in equation (23).

Given the large number of coefficients the bilateral regressions generate, we report a summary of rejections by region definition in Table 6.5 For all choices of the base, for both Administrative Regions and Postcode Areas, and in both 1992 and 1986, the null hypothesis that the estimated coefficients on the regional dummies are equal to zero is easily rejected at the 1% level with a F-test. For Postcode Areas in 1992, 17% of the regionpairs reject relative factor price equality at the 10% level, while 11% reject at the 5% level. Every region rejects with at least 6 other regions. In 1986, 19% of the region pairs reject relative factor price equality at the 10% level, and 12% reject at the 5% level. Every region rejects with at least 5 other regions at the 10% level. For Administrative Regions, we find that 57% of region-pairs reject at the 10% level in 1992 and 40% in 1986.

This corresponds to an average number of rejections against 5 and 4 Administrative Regions respectively, making clear that the rejection of RFPE is not simply driven by the South-East of England. Every region rejects with at least 2 other regions at the 10% level in both years. Taken together, the UK base and the bilateral regression results emphatically reject the null hypothesis of relative factor price equality in the UK.

THE FACTOR PRICE EQUALIZATION.

Robustness

These results are robust across a variety of econometric specifications and to a number of dataset refinements, reported in Table 7. To conserve space, we highlight robustness with respect to the 1992 Administrative Region results. However, similar checks for 1986 Administrative Region and for Postcode Areas display the same robustness. The first column of Table 7 reports the baseline results for factor price equality across Administrative Regions in 1992. The baseline sample for these results includes all establishments, some of which may report o plants in more than one Administrative Region or Postcode Area. We therefore undertake the following two robustness tests. First, in column (2) we report coefficient estimates for the sub-sample of single plant establishments where overlap does not occur and where we find a very similar pattern of results. Second, in column (3), we allocate establishment-level data to plants on the basis of their shares of establishment employment.

All plants associated with an establishment are given the same relative wages and relative wage bills. This robustness test introduces a bias against rejecting RFPE. However, even with this bias, we continue to find a rejection, with the South-East coefficient positive and statistically significant and the Northern, Wales, and Scotland coefficients negative and statistically significant. The baseline sample includes the population of establishments with more than 100 employees and a sample of establishments with fewer than 100 employees. In order to ensure that our results are not being driven by the presence of a non-random sample of smaller establishments, column (4) also reports results separately for the population of establishments with more than 100 employees. Finally, our coefficient estimates are means across all 4-digit industries in each region. Although each region has a large number of establishments across all industries, some individual industries within a region may contain few establishments. Since measurement error at the establishment level is a potential concern, column (5) also reports estimation results dropping all 4-digit region-industries that contain fewer than 5 establishments.

Once again RFPE is rejected and we find a similar pattern of estimated coefficients. The rejection of relative factor price equality in the UK is an extremely robust empirical finding. In the next Section we explore a number of potential explanations for these results.

STRENGTH OF THE PROOF.

First, the conclusion about the effect of opening to free trade is an example of the more general Stolper-Samuelson theorem -- the real returns to the factor used intensively in a rising-price industry increase, and the real returns to the factor used intensively in the falling-price industry decline. This theorem applies in a number of situations, if certain conditions apply (including that the country produces both products both before and after the price change, and that the menu of technologies available does not change).
Second, another way to view the broad pattern of the effects of shifting to free trade (or other shifts which change relative product prices) is through the specialized-factor pattern-factors more specialized in the production of exportable products (or rising-price products more generally) tend to gain income, and factors more specialized in the production of import-competing products (or falling-price products more generally) tend to lose income. This pattern applies to both the short and the long run, and especially applies to factors that can only be used in one industry (sector-specific factors).
Third, the H-O approach has a surprising implication for the earnings of a single factor in different countries. The factor price equalization theorem states that free trade that equalizes product prices between countries also equalizes the prices of individual factors between countries. The logic of this can be developed intuitively. With no trade, the price of a factor will be "high" in the country in which it is scarce and “low in the country in which it is abundant. The shift to free trade increases the factor 's price in the abundant country and decreases its price in the scarce country. Under "ideal" conditions, the factor 's prices (in real terms) become equal in different countries. In its impact on differences in factor prices, product trade can be a substitute for international movement of factors.

WEAKNESS OF THE PROOF.
The factors that gain from free trade are those that are used intensively in export-oriented production, while the factors that lose are those used intensively in import-competing production. The evidence on the factor content of export and import-competing production in the United States and Canada, along with brief comments about other countries.
Finally, the provided evidence on international factor price equalization. While it clearly does not hold perfectly, even if we define factors carefully, we do see tendencies toward factor price equalization. Most obviously, as countries in Asia have integrated themselves into world trade, real wages in these countries have increased rapidly and approach the real wages earned by comparably skilled workers in industrialized countries.

POLICY IMPLICATION.
Multiple Heckscher-Ohlin Cones

The existence of multiple Heckscher-Ohlin cones of diversification within the UK provides a potential true rejection of relative factor price equality. This rejection is based on the immobility of at l east one f actor, which prevent s regional factor prices (and endowments) from converging towards a common value across the country.6 As noted above, a central prediction of the Heckscher-Ohlin model is that the skill premium is inversely proportional to regional skill endowments across cones (see for example Leamer 1995). Graphically, this relationship is apparent in Figure 1, where the slope of the isocost line anchoring unit value isoquants is steeped in the relatively skill abundant cone.

Estimates of quality-adjusted relative wages in Table 3 exhibit just such a violation of factor price equality: for reasonable estimates of the elasticity of substitution between production and non-production workers, we find the skill premium to be lower in the regions around London, where skilled labour is relatively abundant, and higher in outlying areas, where skilled labour is relatively scarce.

The potential existence of multiple cones of diversification within the UK is quite important for formulating public policy, in that it implies asymmetric sensitivity of regions to external shocks. A decline in the price of unskilled labour intensive products on world markets (associated with decreases in tariffs and transport costs, or economic growth of labour abundant economics like China) affects workers differently depending upon their region. Such price declines drive down the return to unskilled workers in low-skill regions while unskilled workers in high-skill regions benefit unambiguously from cheaper imports.

A key empirical prediction of multiple Heckscher-Ohlin cones is that regions will exhibit systematic differences in production structure, with skilled abundant regions producing a set of goods that is more skilled intensive than that in unskilled abundant regions.

Conclusions.

Having examine the extent of relative wage variation across geographic areas of the United Kingdom using a methodology that is robust to unobserved region-industry differences in factor quality, variations in production functions across industries and Hicks-neutral regional technology differences. Despite the United Kingdom being a small, densely-populated country with highly integrated goods markets and the potential for factor mobility, there is strong evidence against absolute and relative wage equality. We find statistically significant and quantitatively important differences in quality-adjusted absolute and relative wages across both broadly defined Administrative Regions as well as more narrowly defined Postcode Areas.
We find that skill abundant regions in the South-East have a lower skill premium than skill scarce regions for plausible values of the elasticity of substitution between skilled and unskilled workers; we examine a number of potential explanations for this finding and highlight additional, empirically verifiable implications of each. Multiple Heckscher-Ohlin cones of diversification and spatial variation in workers’ relative cost of living provide natural explanations for the observed variation in skill premia and have the same implications for production structure across regions of the UK.
Other explanations based on TFP differences, increasing returns to scale, and transport costs require implausible assumptions to be made. More formal testing of the relative importance of each explanation is an interesting area for further research but lies beyond the scope of this paper.
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