L12315: International Trade

The Specific-factors Model

 Reference

Robert Feenstra
3rd edition, Worth Publishers. Chapter 3.
 Gain and lose from trade
Opening a country to trade generates winners and losers NOT win-win
situation.
Once we consider all factors of production (labor, capital and land), trade
generates gains for some factors and losses for other factors of
production.
In general, the gains exceed the losses, and there are overall gains from
trade for both countries.
We assumes that one industry (agriculture) uses labor and land and the
other industry (manufacturing) uses labor and capital. This model is
sometimes called the specific-factors model, because land is specific to
the agriculture sector and capital is specific to the manufacturing sector.
The idea that land is specific to agriculture and capital to manufacturing
might be true in the short-run but not in the long-run.
The next chapter (HO model) develops a long-run model.
 The Specific-factors model

Model assumptions:
2 goods: manufacturing (M) and agriculture (A).
Unlike the Ricardian model there are 3 factors:
Labour, which is used in both M and A and which is mobile.

M.
Technology: Unlike Ricardian model, there is decreasing returns to
labour in M and A;
We assume that the no-trade relative price of manufacturing in Foreign
(P*M/P*A) differs from the no-trade price (PM/PA) at Home, where,
(PM/PA)<(P*M/P*A). So Home has comparative advantage in
manufacturing and trade takes place between Home and Foreign.

1
Diminishing marginal product of labor

2
Diminishing MPL in both industries

3
 Implications of diminishing MPL

Combing the output fro the two industries M and A, we obtain the PPF.
PPF is concave to the origin because of diminishing returns to labour in
both industries.
The slope of the PPF is, PPF slope= -MPLA/ MPLM.
Unlike Ricardian model (CRS), the allocation of labour matters for the
slope of the PPF. If labor is reallocated to manufacturing, MPLA rises and
MPLM falls leading to an increase in the opportunity cost of
manufacturing.

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Concave PPF
we move one unit of labour from agriculture
to manufacturing, i.e. from A to B , this leads to
an increase in QM and a decrease in QA .
of labour from agri to manuf
increases MPLA , but decreases MPLM
means a steeper slope , and thus a
concave shape of PPF

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 Labor allocation in autarky
Firms hire labor up to the point where the cost of one extra hour of
labor (the wage) equals the value of the marginal product of this extra
hour of labor:

6
 Autarky equilibrium

Since we assume that labor is mobile, the wage in the two industries must be
equal:

The relative price of manufacturing, PM/PA is then given by the ratio of the
marginal productivities.
In the autarky equilibrium, consumption occurs where the slope of the PPF is

7
 Autarky equilibrium

Agriculture
Output, QA

A
U1
Slope = (PM/PA)
B

PPF

Manufacturing
Output, QM

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 Foreign Country

We simply assume that the no-trade manufacturing in Foreign (P*M/P*A)

differs from no-trade price (PM/PA) at Home.
For the sake of focusing on one case, let us assume that that Home no-
trade relative price of manufacturing is lower than the Foreign relative
price, (PM/PA)< (P*M/P*A).
This means that Home can produce manufacturing goods relatively
cheaper than Foreign or, equivalently, Home has a comparative advantage
in manufacturing.
Break!
 Move to open trade
Assume now the economy has the opportunity to engage in trade at the
world price,(PM/PA)W ,which exceeds the autarky price.

(PM/PA) < (PM/PA)W <(P*M/P*A)

This will lead to an increase in the relative price of M at home.

The higher price of M will attract more workers into the M-sector.

But since this labour movement will lead to a decline in the MPL in the
M-sector and an increase in the MPL in the A-sector, the economy
experiences a movement along its PPF resulting in a higher opportunity
cost of M in the trade equilibrium.

The trade equilibrium is characterized by incomplete specialization with

free trade production taking place at B.

The free trade consumption lies outside PPF at C; in the

trade equilibrium the country will export M and import A.

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 Free trade equilibrium
Notice that the good whose relative price goes up (M for Home) is exported and
the good whose relative price goes down (A, for Home) is imported.

Agriculture
Output, QA Once
Trade trade
makes is opened
prices and
for
The gains
consumers from
face trade
the can
new be
world
Slope = (PM/PA)W manufacturing
measured by theinrise
Homein rise as
utility
price, they are
seenUfrom new able
pricetoline
obtain a
from
consumption
1 to U .
2 point C on the
C
higher indifference curve (U2)

A U2
Gains from trade
U1
Slope = (PM/PA)
B

PPF

Manufacturing
Output, QM

10
 Labor market equilibrium
The Labor market equilibrium is characterized by two conditions:
Labor demand = Labor supply:
Wages: W = PM MPLM= PA MPLA .
The equilibrium labour allocation can be characterized in a new general
equilibrium diagram for the labour market (next slide).

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Labor market equilibrium
The labor market is in
equilibrium where the

product curves' intersect.

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 Effects of trade on nominal wages
We assumed that the Home economy has a comparative advantage in M.
Trade will then lead to a rise of the relative price of M.
This can be caused by an increase of PM or a decrease in PA.

Assume now that PM increases while PA remains the same.

This implies that the PM M curve shifts up M MPLM. (see Fig.)
Workers will have an incentive to move to the M-sector until wages are
equalized in both sectors.
In the new equilibrium workers in both sectors will benefit from a higher
nominal wage rate. (See Figure in the next slide)

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Change in the labor market equilibrium
The vertical distance between
Increase in the price of M P *MPLM shifts up creating a
theMold and new curves is
new equilibrium.
greater than the increase in w.

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 Effect on real wages in Agriculture
The real wage can be measured either in terms of M or A.
Since we assumed that trade did not affect PA , a rise in W leads to a rise
in W/PA (real wage increased) workers can buy more of A.
The real wage in terms of agriculture goods has increased.

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 Effect on real wages in Manufacturing

But since trade leads to an increase in both PM and W, we need to

investigate the net effect on W/PM (real wages in manufacturing).
Diminishing MPL implies that M·MPLM
Dividing both sides by W [remember, W=PM·MPLM], we obtain :
M·MPLM)/(PM·MPLM M/PM

M/PM .
This indicates that the percentage increase in the price of the
M/PM), is larger than the percentage increase in

The real wage in terms of manufactured goods has decreased.

 Net effect on real wages
The overall welfare effect on labor is ambiguous:
A worker who spends more of her/his income on the agricultural good is
better off.
However, a worker who spends more of her income on the manufactured
goods is worse off.
In the specific-factors model, the welfare effect of trade depends on the
relative spending pattern.

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Earnings of Capital and Land
 Earnings of capital and land
By subtracting the payments to labour from the sales revenue, we find:
Payments to capital = PM·QM W·LM
Payments to land = PA·QA W·LA
K denotes the capital employed in the M-sector and T denotes the land
employed in the A-sector.
RK denotes the return to capital and RT denotes the return to land

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 Earnings of capital and land
Alternatively, RK and RT are determined by their marginal productivities,
because factor price or return = value of marginal product of the factor

Recall we assumed that PM increases and PA is constant.

Recall that labor shifts from A to M.
As more labour is used in manufacturing, the marginal product of capital
MPKM will rise. (since capital now works with more labour)
So RK must increase
As labour leaves agriculture, the marginal product of land MPKA will fall.
(since land now works with less labour)
So, RT must decrease

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 Earnings of capital
Real earnings in terms of M:
RK = P M M
MPKM = RK/PM
We know, PM is increasing and we also know that MPKM is increasing.
So, RK must be increasing by more than PM.
Real earning increases for capital owners in terms of M-goods.
Real earnings in terms of A: RK/PA
RK increased, PA is fixed, so RK/PA increases.
Capital owners can purchase more of A-goods.
Capital owners are clearly better off in nominal and real terms.

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 Earnings of land
Labor leaves agriculture, causing MPTA to fall.
RT = PA A
MPTA = RT/PA,
RT/PA must fall, meaning RT itself must fall (since PA remains constant).
Apparently , in terms of A-goods RT/PA = MPTA
has decreased.
Since PM has increased, RT/PM must fall, so landowners are also worse
off in terms of M-goods.
Overall, landowners are clearly worse off in nominal and real terms.

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 Earnings of capital and land

Summary
Real earnings of capital and land owners move in opposite directions.
An output will increase the
real rental earned by the factor specific to that industry, but will decrease
the real rental of the factors specific to the other industry.
Specific factors in export industries gain and specific factors in import
competing industries lose from trade liberalization.

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Break!
 Numerical example

Manufacturing:
Sales Revenue = PMQM = $100
Payments to Labor = WLM = $60
Payments to Capital = RKK = $40
Agriculture
Sales Revenue = PAQA = $100
Payments to Labor = WLA = $50
Payments to Land = RTT = $50

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 Numerical example

Assume PM increases by 10% and PA remains unchanged. Assume the

percent change in wages is 5%.
M/PM = 10%

A/PA = 0%

Remember that the percent change in wages will be between the

percent change in the price of M and A.

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 Numerical example

Change in the rental on capital

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 Numerical example

Change in the rental on capital

K/RK = (10%*100-5%*60)/40 = 17.5%
The percentage increase in rental on capital is greater than the
percentage increase in the relative price of manufacturing, which is
10%.

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 Numerical example
Change in the rental on land
Using the same analysis, we can see how rental rates are affected by an
increase in PM . Change in PA is zero.

Since the wage is increasing, we know that the rent on land must be falling.
We can calculate by how much.

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 Numerical example

The land rent falls by the same percentage as the wage rate increases.
This occurs because we assumed labor and land received the same
share of sales revenue.
 Ranking of goods and factor price changes

The percentage changes in factor and goods prices can be written down as
a chain ranking.
We can consider four cases.
Case 1 M A =0:
We obtain the following chain (or set of inequalities):

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 Ranking of goods and factor price changes

Case 2 M A =0:
Find the result (chain ).
Case 3 A M =0:

Case 4 A M =0:
Find the result. (chain 2)

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 Summary
In the specific-factors model the direction of specialization and trade is
also governed by comparative advantage; but there is incomplete
specialization.
Like in the Ricardian model, trade can make a country better off as a
whole, i.e. the aggregate gains from trade are positive.
However, in the specific-factors model, some factors are predicted to
lose from international trade.
The factor specific to the exporting industry enjoys an increase in its
real income.
The factor specific to the import competing industry suffers a fall in its
real income.
Since labor is mobile, the welfare effects of labor depend on the
consumption patterns. Real wages rise in terms of one good but fall in
terms of the other.

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 Application:
change in the world price of coffee

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 Trade and Resource:
The Heckscher-Ohlin model