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Feenstra and Taylor

Specific Factors Model

Chapter 3 Questions.

1.Why is the specific factors model a short-run model?

In the longer run all factors can change: firms can increase their capital by investment or let it run down through
depreciation, or do both at once (let the capital in their steel mills depreciate and direct new investment to land
(which can include exploration for oil or minerals).
The amount of land can increase if exploration pays off, and even the amount of land available for agriculture
can increase by irrigation (or decrease by encroachment of suburbs on what was previously farmland). We will
see in the next chapter than the Heckscher-Ohlin-Samuelson model is a long-run model.

2.Are wages really the same among industries? Of course not; see figure 3-8 in the text. Both the Ricardian
and the specific-factors model simplify reality.

3.Will there be gains from trade if either good increases in price? YES.
This sounds counter-intuitive will you come out ahead if housing increases or decreases in relative price? (The
answer to that is YES too, as long as you have other assets than a house).
In both the housing case and the trade case, you can move to a higher indifference curve. Diagram 3-4 in the text
showed the price of manufactures (on the X-axis) increasing and a move to a higher indifference curve; the
diagram below shows the result if the relative price of agricultural goods (on the Y axis) increases.
4.What happens if the price of manufactures decreases in the text specific factors model? See the graph
below. The percentage fall in wages will be LESS than the percentage change in the price of manufactured
goods, because the fall in the price of manufactured goods will lead to less labor in the industry and therefore an
increased marginal product of labor. Since the formula WAGE = P * MPL implies that

% WAGE = % P + % MPL, if the MPL increases, the fall in wages will be LESS than the fall in price.

The price of manufactured goods falls from $ 200 to $ 100, while the price of agricultural goods stays constant at
$ 100. MPL in manufacturing was initially shown by the magenta line; after the fall in price, by the red line.
Wages fall not by $ 100, but from $ 236 to $ 186 (in the class example; see separate handout).
As fewer workers work in the manufacturing sector, the MPL RISES (each worker has more capital to work
with), partly offsetting the decline in price. The real wages of workers in terms of manufactured goods have risen
from wage / Pm = $ 236 / $ 200 = 1.18 to $ 1.86 / $ 100 = 1.86; but they have fallen in terms of agriculture,
from 2.36 to 1.86. The welfare of workers may have improved or deteriorated.
5.Effect of change in price on rents of land and of capital.The formula given in the text for the impact is an
approximation which is best for small changes in prices and production. It may be derived as follows:
(See the document titled Percentage Changes for a more detailed derivation)

(Pa = Price of agricultural goods; Qa = quantity of agricultural goods, La = Labor in agriculture):

Rent * Land = Pa * Qa - w * La

Land * Rent = Qa * Pa - La * w (assuming that La and Qa do NOT change)

We want to convert this into PERCENTAGE changes; to divide Rent by Rent, w by w, Pa by Pa.
Note that the requires us to multiply the term Land * Rent by Rent divided by Rent (=1). So we have:

Land * Rent * % Rent = Pa * Qa * % Pa - w * La * % w

We have the information in the problem: Pa * Qa = 150, w * La = 50, Land * Rent = 100, so:

100 * % Rent = 150 * % Pa - 50 * % w and now substituting the 10 percent rise in the
price of agricultural goods and the 5 percent change in wages (arbitrary values, except for the fact that
the percent change in wages is less than the percent change in price) we have (dividing by 100):
% Rent = 1.5 * % Pa - 0.5 * % w = 1.5 (10%) 0.5 (5%) = 15% 2.5% = 12.5 %
The return to land has risen MORE than the price of agricultural goods, and also obviously in terms
of the price of manufactured goods (which is unchanged).

Using the same technique for the Return to capital * Capital = Pm * Qm - w Lm, with initial values
as given in the problem (Pm * Qm = 150, wLm = 100, Rk * K = 50), we find:
50 * % Rk = 150 * % Pm - 100 * % w or (dividing by 50):
% Rk = 3.0 * % Pm - 2.0 * % w = 3.0 * 0 - 2.0 * 5% = -10%
Since all prices have either stayed the same or increased, there is no question that the owners of capital
are worse off.

Workers wages have risen by 5 percent so their real wages rise in terms of manufactures.
But the price of agricultural goods has risen by 10 percent more than the wages of workers.

See the document titled Returns to Specific Factors for a more precise estimation of the changes
in returns to capital and land, using the more accurate percentage change relations.

6. Effect of a change in price (fall in price of manufactures by 10 percent, fall of wages by 5 percent). You
can check that the results will be a
50 * % Rk = 150 * % Pm - 100 * % w
% Rk = 3.0 * % Pm - 2.0 * % w = 3.0 * (-10%) - 2.0 * (- 5 %) = -30 % + 10 % = -20%

Note that since the price of agricultural goods does not change, rents will increase due to the fall in
wages. Again, the exact amounts are in the document Returns to Specific Factors.

7. Proposals for relieving worker anxiety.

There is a link in the course website to the Kletzer/Litan article, and to the article by Howard Rosen,
Designing a National Strategy for Responding to Worker Dislocation (June 24, 2008).
8. Magnification effects in the specific factors model.
If the price of agricultural goods declines, the returns to land will decline by a greater percentage than
the price. See the answer to the problem 6, where a fall in manufacturing prices of 10 percent led to a 20 percent
fall in the return to capital (see the Returns to Specific Factors document for more exact figures, but the
magnification effect remains) The real return to capital will increase, thanks to the decline in agricultural prices.
Workers will partly protect themselves against the decline in price of agricultural goods, since they can move
into the manufacturing industry. They therefore are able to purchase more agricultural goods. But because there
are more of them in manufacturing, the value of their marginal product will fall, and their new wages will not
purchase as many manufactured goods.

Translated into inequalities:

% Rt < % Pa < % w < % Pm = 0 < % Rk

9. Canada and Mexico

Canada will export timber and import televisions; the relative price of timber rises in Canada and the relative
price of televisions falls in Canada. In a specific factors model:
a. The impact on the real wage is ambiguous. Wages do not rise as much as the price of timber, so
presumably housing will become more expensive; but wages do rise (draw a graph like Fig. 3-6 to see this) and
the prices of TVs fall, leaving workers able to put a bigger TV set in their smaller rooms.
b. The magnification effect on real returns means that landowners (with forests on their land) will
definitely win, and capitalists (with television factories) will definitely lose.
c.Since the relative price of timber falls in Mexico and the relative price of televisions rises, the pattern
of gains will be the opposite of Canada's capitalists win in Mexico, landowners lose, and workers are again in
an ambiguous position (now with bigger houses and smaller-screen TVs)
d. The specific factor in the export industry gains, and the specific factor in the import-competing
industry loses. This foreshadows the important Stolper-Samuelson result in the next chapter.

10-11. Factor abundance, production possibility frontiers, and prices before trade.
The PPFs should not be hard to draw: Home can produce a lot of computers and not much in the way of
wheat. With production functions of the form Q = (sqrt K*L) and Q = (sqrt T*L) we would have:
In HOME: Qc = 10 (sqrt Lc) and Qw = (sqrt 10) * (sqrt Lw), so that Home produced a maximum of
Qcmax = 100 computers and Qwmax = 31.623 units of wheat. In a Ricardian model this would imply
that wheat is 3 times as expensive as computers in Home; the result in a specific factors model will
depend on the exact pattern of consumer demand, but we can be fairly sure that wheat will be more
expensive in Home.

In FOREIGN, Qc = (sqrt 10) * (sqrt Lw) = 3.1623 * ( sqrt 100) = 31.623 at a maximum, and the
maximum output of wheat would be 100. The price of wheat, we can be fairly sure, will be less than
the price of computers.

Note in this example, both countries had the same production functions, but different factor
endowments, and the factor endowments shaped their autarky relative prices and hence their comparative
advantage: Foreign will export wheat, and Home computers, not because of inherently superior productivity, but
because factor endowments shape comparative advantage. We will find that this is the way in which the
Heckscher-Ohlin model explains comparative advantage as well.

As in the Canada-Mexico example, the specific factor in the export industry gains and the specific factor
in the import industry loses: in HOME, capitalists win and landowners lose; in FOREIGN, capitalists lose and
landowners win. In both countries, the impact on the mobile factor (labor) is ambiguous.