chapter 4: specific factors and income distribution

there are 2 main reasons why international trade has strong effects on the distribution of income within a country

1. resources cannot move immediately or costlessly from one industry to another

2. industries differ in the factors of production they demand

the specific factors model allows trade to affect

income distribution

what are the assumptions of the specific factors model

• two goods (e.g., cloth and food)

• three factors of production (e.g., labor, capital, and land)

• perfect competition prevails in all markets

• cloth produced using capital and labor

• food produced using land and labor

• labor is a mobile factor that can move between sectors

• land and capital are both specific factors used only in the production of one good

when labor moves from food to cloth

food production falls while output of cloth rises

the production function for cloth (graph)

the more labor employed in the production of cloth, the larger the output. as a result of diminishing returns, however, each successive person-hour increases output by less than the previous one; this is shown by the fact that the curve relating labor input to output gets

the shape of the production function reflects the law of

diminishing marginal returns

diminishing marginal returns

adding an additional factor of production results in smaller increases of output

marginal product of labor

the change in the level of output when a new employee is hired, given that all else remains constant

marginal product of labor (graph)

the marginal product of labor in the cloth sector, equal to the slope of the production function shown in the graph, is lower the more labor sector employs

use a four-quadrant diagram to construct production possibilities frontier

• lower left quadrant indicates the allocation of labor

• lower right quadrant shows the production for cloth

• upper left quadrant shows the corresponding production function for food

• upper right quadrant indicates the combinations of cloth and food that can be produced

the production possibility frontier in the specific factors model

PP in the upper right quadrant shows the economy’s production possibilities for given supplies of land, labor, and capital. due to diminishing returns, PP is a bowed-out curve instead of a straight line

why is the production possibilities fronntier curved

• diminishing returns to labor in each sector cause the opportunity cost to ride when an economy produces more of a good

• opportunity cost of cloth in terms of food is the slope of the production possibilities frontier - the slope becomes steeper as an economy produces more cloth

how much labor is employed in each sector

need to look at supply and demand in the labor makret

demand for labor:

in each sector, employers will maximize profits by demanding labor up to the point where the value produced by an additional hour equals the marginal cost of employing a worker for that hour

if the wage were higher in the cloth sector

workers would move from making food to making cloth until the wages become equal

the allocation of labor (graph)

labor is allocated so that the value of its marginal product (P x MPL) is the same in the cloth and food sectors. in equilibrium, the wage rate is equal to the value of labor’s marginal product

production in the specific factors model (graph)

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 to the allocation of labor and the distribution of income when the prices of food and cloth change

• an equal proportional change in prices

• a change in relative price

when both prices change in the same proportion

no real changes occur

the wage rate (W) rises in the same proportion as the prices. so,

real wages (i.e., the ratio of the wage rate to the prices of goods) are unaffected

an equal-proportional increase in the prices of cloth and food (graph)

the labor demand curve in cloth and food both shift up in proportion to the rise in P_c from P_c¹ to P_c² and the rise in P_F from P_F¹ to P_F². the wage rate raises in the same proportion, from W¹

to W² but the allocation of labor between the two sectors does not change

a rise in the price of cloth (graph)

the cloth labor demand curve rises in proportion to the 7% increase in P_c, but the wage rates rise less than proportionately. labor moves from the food sector to the cloth sector. output of cloth rises; output of food falls

the response of output to a change in the relative price of cloth

the economy always produces at the point on its production possibility frontier (PP) where the slope of PP equals minus the relative price of cloth. thus, an increase in P_c > P_F

causes production to move down and to the right along the production possibility frontier corresponding to higher output of cloth and lower output of food

determination of relative prices (graph)

in the specific factors model, a higher relative price of cloth will lead to an increase in the output of cloth relative to that of food. thus, the relative supply curve RS is upward sloping. equilibrium relative quantities and prices are determined by the intersection of RS with the relative demand curve RD

suppose that P_c increases by 10%

then the wage would rise by less than 10%

what is the economic effect of this price increase on the incomes of the following 3 groups:

• workers

• owners of capital

• owners of land

owners of capital

are better off

landowners are

worse off

workers cannot say whether workers are better or worse off

depends on the relative importance of cloth and food in workers’ consumption

the relative price of cloth prior to trade is determined by

the intersection of the economy’s relative supply of cloth and its relative demand

free trade relative price of cloth is determined by

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

opening up to trade increases

the relative price of cloth in an economy whose relative supply of cloth is larger than for the world as a whole

trade and relative prices (graph)

the figure shows the relative supply curve for the specific factors economy along with the world relative supply curve. the differences between the two relative supply curves can be due to either technology or resource differences across countries. there are no differences in relative demand across countries. opening up to trade induces an increase in the relative price from (P_c>P_F)¹ to

(P_c>P_F)²

without trade, the economy’s output of a good must

equal its consumption

the economy as a whole

gains from trade

budget constraint for a trading economy and gains from trade

point 2 represents the economy’s production. the economy can choose its consumption point along its budget constraint (a line has a slope equal to minus the relative price of cloth). before trade, the economy must consume what it produces, such as point 1 on the production possibility frontier (PP). the portion of the budget constraint in the colored region consists of feasibly post-trade consumption choices, with consumption of both goods higher than at pre-trade point 1

international trade shifts the relative price of cloth to food

so factor price changes

trade benefits the factor that is specific to the export sector of each country, but hurts

the factor that is specific to the import-competing sectors

trade benefits a country by

expanding choices

trade produces both

winner and losers

how can everyone receive gains from trade

possibly to redistribute income

those who gain from trade could compensate

those who lose and still be better off themselves

everyone could gain from trade but

that does not mean they do - redistribution is usually hard to implement

optimal trade policy

must weigh one group’s gain against another’s loss

some groups may need special treatment because

they are relatively poor (e.g., shoe and garment workers in the United States)

most economists strong favor

free trade

typically, those who gain from trade are

much less concentrated, informed, and organized group than those who lose

example: consumers and producers in the U.S. sugar industry, respectively

governments usually provide a “safety net” of income support to

cushion the losses to groups hurt by trade (or other changes)

how much employment can be traced back to trade

from 2001 to 2010, only about 2% of involuntary displacements stemmed from import competition or plants moved overseas

(the graph) shows that there is np evidence of a positive correlation between unemployment and imports (relative to U.S. GDP) for the U.S.

after 2012, both imports and unemployment do drop significantly; however, the drop in imports was driven by falling oil prices. non-oil imports as a share of U.S. GDP remained stable in those years