Factor Substitution and Relative Factor Prices

Abstract

This paper examines the effects of factor endowments on factor prices in a three-factor, two-commodity general-equilibrium model with endogenous commodity demand and prices. Unlike the conventional small open-economy model that assumes constant commodity prices, factor substitution influences the direction of these effects. When a factor endowment increases, complementarity with the expanding factor benefits an unchanged factor, but substitutability harms it. If the unchanged factors are complements, there is a possibility of a rise in the expanding factor's price. A comparison of this closed-economy model with the small open-economy model reveals the role of international trade, which dampens the effect on the expanding factor's price.