Specific factors and income distribution 2.0

Main reasons why international trade has strong effects on the distribution of income.

1. Resources cannot move immediately or costlessly from one industry to another
2. Industries differ in the FoP they demand

The specific factors model

• Allows trade to affect income distribution

• Three FoP: L, K and T

• Assumes an economy produces two goods

• Labour is a mobile factor that can move between sectors

• T and K are both specific factors used only in the production of one good

MPL

Increase of output that corresponds to an extra unit of labour

Why does the PPF bow outward?

Diminishing returns to labour in each sector cause the OC to increase when an economy produces more of one good

What determines the amount of labour employed?

Supply and demand

Demand curve for labour in the cloth sector

MPLc x Pc =W

VMPL =W

Production in the specific factors model

The economy produces at the point on its production possibility frontier ( PP ) where the slope of that frontier equals minus the relative price of cloth.

What happens when both prices change in the same proportion?

• Wage rate increases in the same proportion as the prices, so real wage is unaffected.

• Real incomes of capital owners and land owners also remain the same

What happens when one of the goods price increases (such as cloth)?

Labour shifts from the food sector to the cloth sector and the output of cloth increases. The wage rate does not rise as much as Pc since cloth employment increases and thus MPL in that sector decreases

How is free trade relative price of cloth determined?

By the intersection of world relative supply of cloth and world relative demand

Gain from trade

Without trade, the economy's output of a good must equal its consumption

Factor mobility

Measures the extent to which factor inputs such as land, labour and capital can easily switch between alternative uses with no loss of efficiency