The theory of factor price equalisation - often regarded as a somewhat dry and dated economic concept - offers an interesting approach to recent developments in economic integration between Hong Kong and the Mainland.
Those who have studied economics will be familiar with the theory of factor price equalisation. According to this theory, the prices of the factors of production - land, labour and capital - of two economies trading with each other will, under certain assumptions, equalise. At the time when the theory was developed, the focus of analysis was on the effects of international trade. No consideration was given to the question of the mobility of the factors of production, or the lack of it, across the two economies. This was probably partly because factor mobility was not a possibility at the time. Factors of production were, physically, traditionally, or by policy design, immobile and not tradable on any significant scale between economies, although the goods produced from their utilisation were. But even without factor mobility, in the simplified model on which the theory was based, the prices of the factors of production would be equalised through external trade. It is not easy to test the validity of this theory. In any case, the theory can only be as good as the assumptions, and the assumptions are rather heroic and unrealistic in present day circumstances. Furthermore, the empirical evidence is conflicting. As we are aware, in the real world, there is an abundance of examples of factor price disparity as well as equality, associated with free or restricted trade.
This practical phenomenon reflects the fact that the real world is a lot more complex than the two-economy, two-commodity, barter-trade, factor-price equalisation model. For example, non-tradable goods (i.e. goods that are not traded internationally) now form the greater part of consumption, and their provision correspondingly demands the use of the greater part of the factors of production. Being non-tradable goods, their prices, and thus the derived prices for the factors of production used in their production, are not subject to the same external price equalisation influence through trade.
On the other hand, to a varying degree the factors of production themselves have become mobile across different economies, as a result of liberalisation, globalisation, and advances in transport facilities and information technology. Although land is immovable, the possibility of ownership by non-residents constitutes a certain degree of mobility. Labour is mobile where there is immigration and importation. And capital has become highly mobile, after the general abolition of exchange controls in the seventies and more recently with globalisation of financial markets, although there are still exceptions. Factor mobility has added a new dimension that works towards factor price equalisation.
You may wonder what is the purpose of this academic recital. The simple answer is that the subject matter is very relevant to Hong Kong in its increasing economic integration with the Mainland. An attempt to examine the dynamics of increasing trade and factor mobility between Hong Kong and the Mainland, in theoretical and practical terms, may be helpful to our understanding of what is going on in Hong Kong and the policy implications thereof.
Trade between Hong Kong and the Mainland has recently received a big boost, in that even the non-tradable goods have become tradable. This was made possible by the ease of the mobility of the consumer (not labour), much more so however for the Hong Kong consumer than for the Mainland consumer. Dinners, massages, haircuts, golf, and even a home just north of the border, being now an hour or so away in reasonably comfortable transport, and without too much hassle at the immigration counters, have all become popular. 24-hour crossing, if it becomes a reality, will give this trend an even bigger push, simply because the demand is there. It will be there for as long as there is a significant price disparity in the provision of these services in the two economies, even after taking account of time, commuting and other relevant costs. In time, this disparity in the prices of goods and services will be compressed, if not eliminated, by the market, and in the process it will force a greater degree of factor price equalisation.
The mobility in the factors of production across two economies will have a much more direct impact on factor prices than trade will have. The extent and the speed with which factor prices equalise depend on the degree of mobility allowed. The process of factor price equalisation inevitably involves inflation in the low factor price economy and deflation in the high factor price economy. The process could be quite destabilising for both economies and certainly has policy implications. It will be useful, therefore, to examine Hong Kong's situation, in respect of the mobility of each of the three factors of production between Hong Kong and the Mainland. I shall tackle this subject next week.
Joseph Yam
15 November 2001
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