Factor Flow:

Factor flows substitute for trade flows. The classical economists generally chose the special case where factors of production were internationally immobile. Factor flows can give rise to commodity price equalization, much as in the standard H-O-S model goods trade gives rise to factor price equalization. Mundells analysis implies that focusing on trade as a proxy for openness may be misleading when international capital flows are significant. Empirically, it is important to consider whether this bias is significant and systematic in a particular direction. Mundell studied the relationship between factor flows and trade in an H-O-S model. He considered a situation where a prohibitively-high tariff on imports shuts off trade and raises the return to capital in the country where it is the relatively scarce factor. This leads to a capital inflow to that country and, through the Rybczynski effect, an increase in the production of the capital-intensive good and a decrease in the production of the labor-intensive good (which had been the export). Capital inflows continue until relative factor endowments in the two countries are identical. If the tariff were then removed, there would be no trade in goods. The reason is that the initial basis for trade in this model, autarky differences in relative factor endowments and the accompanying differences in relative goods prices, has been eliminated through factor flows. More broadly, in a model of this nature, an increase in the volume of factor flows causes a decrease in the volume of trade. Several issues need to be examined when considering the historical links between international factor movements and international trade, and whether increases in factor flows stimulated trade or vice versa, such as the extent to which increased trade and factor mobility foster economic growth and development, how different factor flows are related, whether labor movements induce capital flows or vice versa, whether alternative types of factor mobility substitutes or complements, and whether trade liberalization promotes factor mobility.