I'm trying to develop some intuition for why factor prices are independent of factor endowments in a small open economy (in a standard Heckscher-Ohlin 2x2x2 setting with diversification and no factor intensity reversals).
I've come across explanations like - if the endowment of labor increases, the extra labor will get absorbed by the labor intensive industry. However, I fail to intuitively grasp what that really means and how it implies that factor prices will not change.
The story I've come up with so far is this:
- Labor endowment increases.
- Labor becomes relatively abundant in the economy while capital becomes relatively scarce. This leads the wage to fall and the rental rate of capital to increase.
- Since the prices at which the two industries remain the same, 2. causes there to be positive profits in the labor intensive industry and negative profits in the capital intensive industry.
- This increases the demand for labor and capital in the labor intensive industry and increases the supply of labor and capital in the capital intensive industry.
- Demand for labor increases by more than the supply of labor, while demand for capital increases by less than the supply of capital. This leads the wage to increase and the rental rate of capital to fall.
- The wage and the rental rate of capital return to their original levels.
Is my explanation correct? If it is, how can we intuitively (!) tell that 6. follows from 5. (that we actually get back to the original factor prices)? Does anyone have a better explanation?