Chapter 4. Specific Factors and Income Distribution

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1 Chapter 4 Specific Factors and Income Distribution

2 Introduction So far we learned that countries are overall better off under free trade. If trade is so good for the economy, why is there such opposition? ECON40710 University of Notre Dame 4-2

3 Introduction Opening a country to trade has strong effects on the distribution of income within a country: Some industries contract resulting in unemployment Some industries expand resulting in higher wages This happens because in general: Resources cannot move immediately or without cost from one industry to another. Industries differ in the factors of production they demand. ECON40710 University of Notre Dame 4-3

4 Introduction What is the impact of trade on the distribution of income within a country? In the Ricardian model, there is only one factor of production (labor), so we cannot study the effect of trade on income distribution. We need to develop new models that include many factors of production: Specific-factors model (Chapter 4) Heckscher-Ohlin model (Chapter 5) ECON40710 University of Notre Dame 4-4

5 Outline The Specific-Factors Model Earnings of labor Earnings of specific factors (Capital and Land) Summary and conclusions ECON40710 University of Notre Dame 4-5

6 Specific-Factors Model Assumptions of the model 1. Two sectors: Agriculture and Manufacturing. 2. Three factors of production: labor (L), capital (K) and land (T for terrain). 3. Perfect competition prevails in all markets. ECON40710 University of Notre Dame 4-6

7 Specific-Factors Model 1. Supply The economy produces Manufacturing and Agricultural goods Manufacturing uses labor and capital: Q M = F M (L M,K M ) Agriculture uses labor and land: Q A = F A (L A,T A ) Labor is mobile across sectors but capital and land are specific to their industry (immobile) ECON40710 University of Notre Dame 4-7

8 Specific-Factors Model Full employment in factor markets implies that: L K T M A M + L = K = T A = L ECON40710 University of Notre Dame 4-8

9 Specific-Factors Model In each industry, the marginal product of labor declines as the amount of labor used in the industry increases. This happens because there is a fixed amount of the specific factor. ECON40710 University of Notre Dame 4-9

10 Specific-Factors Model The MRT (slope of the PPF) is: MRT = Q Q A M = MPL MPL A M Because of decreasing returns to scale, as the relative quantity of labor used in the manufacturing sector increases: MPL M decreases MPL A increases As a result, the MRT becomes more negative as the relative output of manufactures increases: The PPF is concave to the origin. ECON40710 University of Notre Dame 4-10

11 Specific-Factors Model Production Possibilities Frontier ECON40710 University of Notre Dame 4-11

12 Specific-Factors Model In a competitive economy, profit maximizing firms will hire labor up to the point where the marginal cost of labor equals the marginal revenue. W = P MPL Since labor is mobile across sectors and both goods are produced, the wage rate must be the same in both sectors: W = P MPL = P MPL A A This implies that the (closed economy) relative price is equal to the opportunity cost: P A MPL = M P MPL M A M M ECON40710 University of Notre Dame 4-12

13 Specific-Factors Model 2. Demand Assume that consumer preferences can be represented by wellbehaved indifference curves 3. Equilibrium Consumers maximize their utility: MRS = P M P A Firms maximize profits: All markets clear MRT = P M P A ECON40710 University of Notre Dame 4-13

14 Specific-Factors Model 4. Foreign country Same as Home expect for endowments Assume Home has comparative advantage in manufacturing The autarky relative price of manufactures in Foreign is higher than in Home ( P M */P A * > P M /P A ) When trade is allowed the relative price of manufacturing goes up in Home ECON40710 University of Notre Dame 4-14

15 Specific-Factors Model 5. Autarky and Trade Equilibrium Q A Autarky (point A): production and consumption are equal. C Slope = (P M /P A ) W With trade supply (B) and demand (C) no longer need to be equal. A U 1 U 2 Home exports M and imports A B PPF Q M The rise in utility from U 1 to U 2 is a measure of the gains from trade for the economy. ECON40710 University of Notre Dame 4-15

16 Specific-Factors Model As in the Ricardian model, the country s income is higher so the welfare of the average consumer is higher. However, in the specific factors model that does not imply that every individual is better off. How are earnings of labor, capital, and land affected in importing and exporting industries after trade? Specific factors model notes ECON40710 University of Notre Dame 4-16

17 Summary Following an increase in the relative price of manufactures: Labor can buy more food but less manufactures. So the welfare effect on workers (the mobile factor) is ambiguous. Capital (specific to manufactures, the export good) owners can afford more of both goods, they are better off. Land (specific to agriculture, the import good) owners can afford less of both goods, they are worst off. ECON40710 University of Notre Dame 4-17

18 Trade Politics In the specific-factors, trade benefits a country by expanding choices but not everyone gains from trade. However, those who gain from trade could compensate those who lose and still be better off themselves. Redistribution usually hard to implement. ECON40710 University of Notre Dame 4-18

19 Trade Politics Optimal trade policy must weigh one group s gain against another s loss. Some groups may need special treatment because they are already relatively poor Typically, those who gain from trade are a much less concentrated, informed, and organized group than those who lose. ECON40710 University of Notre Dame 4-19

20 Trade Politics Most economists favor free trade It is easier to use macro policies to reduce employment than to regulated each industries separately Policies introduce distortions It is difficult to evaluate the (full general equilibrium) impact of. ECON40710 University of Notre Dame 4-20

21 Trade Politics Trade shifts jobs from import-competing to export sector. Process not instantaneous some workers will be unemployed as they look for new jobs. Governments usually provide a safety net of income support to cushion the losses to groups hurt by trade (or other changes). How much unemployment can be traced back to trade? No clear pattern ECON40710 University of Notre Dame 4-21

22 Trade Politics ECON40710 University of Notre Dame 4-22

23 Conclusions In the specific-factors model an increase in the relative price of an industry s output will: Have an ambiguous impact on the welfare of the mobile factor Increase the real rental earned by the factor specific to that industry Decrease the real rental of factors specific to other industry ECON40710 University of Notre Dame 4-23

24 Conclusions In the specific-factors model: Trade benefits a country by expanding choices Not everyone gains from trade However, the gains outweigh the losses: Those who gain from trade could compensate those who lose and still be better off themselves That everyone could gain from trade does not mean that they actually do redistribution usually hard to implement ECON40710 University of Notre Dame 4-24

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