International Economics

Specific-Factor Model

Giuseppe Berlingieri
giuseppe.berlingieri@essec.edu
@g berlingieri

ESSEC Business School

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Outline of the Course
I Introduction to International Trade

I Classical Trade Theory: Trade Patterns & Winners/Losers

I The Ricardian Model
I The Specific-Factors Model
I The Heckscher-Ohlin Model

I Trade and Inequality

I New Trade Theory: Trade Patterns & Policy

I External Economies of Scale
I Industrial (and Trade) Policy
I Market Power and Imperfect Competition

I Firms in the Global Economy

I Heterogeneous Firms
I Multinationals, FDI and Offshoring

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Outline

Introduction

Model

Application

Conclusion

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Introduction

I The Specific-Factors model was developed in the 1970s by Paul

Samuelson and perfected by Peter Neary.
I Big Questions: Trade Patterns
I Trade is again due to comparative advantage.
I The source of comparative advantage is differences in factor
endowments.

I Winners and Losers from Trade

I How trade affects different factors of production.

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Distribution of Income

I Ricardian Model
I Only one factor of production that moves freely from one industry to
another.
I Not only all countries gain from trade, but also every individual is
made better off as a result of international trade.

I In the real world international trade has strong effects on the

distribution of income because:
I Factors cannot move immediately or without cost from one industry
to another, a “short-run” consequence of trade.
I Industries differ in the factors of production they demand. A shift in
the mix of goods produced shifts demand from one factor to another,
a “long-run” consequence of trade.

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Outline of the Lecture

I Assumptions of the basic model

I The relationship between changes in goods prices and factor prices

I The effect of changes in the endowments on prices

I Trade patterns and economic welfare

I Application

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Outline

Introduction

Model

Application

Conclusion

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The Basic Model

I Two countries, France (home) and Brazil (foreign)

I All foreign (Brazilian) variables carry an asterisk (*)

I Two goods cloth (c) and food (f)

I Both countries are endowed with fixed quantities of three factors of

production: labor (L), land (T ) and capital (K ).

I As in the Ricardian model there is a representative consumer with

identical and homothetic preferences.

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Production
I Technology is the same in both countries. The production functions
tell you how much output can be produced for any given input:

Qc = F (K , Lc ) Qf = H(T , Lf )

I Output of cloth depends on capital (K ) and labor (Lc )

I Output of food depends on land (T ) and labor (Lf )

I Labor is perfectly mobile between both sectors, but land and capital
are specific to one sector.

I As in the Ricardian model there is perfect competition.

I Assumptions about F (K , Lc ) and H(T , Lf )

I Constant returns to scale (CRS)
I FL , HL > 0 and FLL , HLL < 0 (Diminishing returns)
I FLK , HLT > 0 (Factors are complements)

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Returns to Scale

I Production exhibits constant returns to scale if for a given increase in

all inputs, output increases by the same proportional change:

F (z · K , z · Lc ) = z · F (K , Lc )

H(z · T , z · Lf ) = z · H(T , Lf )

I An implication is that production exhibits diminishing returns in any

single factor, for instance for labour:

F (K , z · Lc ) < F (z · K , z · Lc ) = z · F (K , Lc )

H(T , z · Lf ) < H(z · T , z · Lf ) = z · H(T , Lf )

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Production Function
Increasing in Inputs and Diminishing Marginal Returns to Inputs

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Marginal Product of Labor
I Equivalently, the marginal product of any single factor (how much an
increment of that factor adds to production) is decreasing.
I Adding a worker in cloth/food means that each worker has less
capital/land to work with: each successive increment of labor will
add less to production than the last.

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Production Possibilities
I The production possibility frontier (PPF) shows the maximum
amount of a goods that can be produced with its factors

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Production Possibilities
I As in the Ricardian model, the slope of the PPF is the opportunity
cost of cloth in terms of food: how much food production falls when
cloth production (marginally) rises.
I Why is the production possibilities frontier curved?
I Diminishing returns to labor in each sector cause the opportunity cost
to rise when an economy produces more of a good.
I Hence the slope of the PPF (opportunity cost of cloth in terms of
food) becomes steeper as an economy produces more cloth.

I Opportunity cost of producing one more metre of cloth is

MPLf /MPLc kg of food.
I To produce one more metre of cloth, you need 1/MPLc hours of labor.
I To free up one hour of labor, you must reduce output of food by
MPLf pounds.
I The marginal product of labor in food rises and the marginal product
of labor in cloth falls, so MPLf /MPLc rises.

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Actual Production

I Suppose the France faces given world prices Pf and Pc

I What will be the allocation of labor between the two sectors?

I Profit maximization by cloth producers:

max Pc F (K , Lc ) − wLc (1)

Lc

I FOC:
Pc FL (K , Lc ) = w (2)

I Similarly, the FOC for food producers is:

Pf HL (T , Lf ) = w

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Actual Production
I Mobile labor arbitrages out any difference in wages between sectors.

I Hence the wage w is the same in cloth and food.

I As labor is paid the value of its marginal productivity, when both

goods are produced:

VMPLc = Pc MPLc = Pc FL (K , Lc ) = w

VMPLf = Pf MPLf = Pf HL (T , Lf ) = w

I Hence labor moves between sectors until cloth output and food
output are such that sectoral wages are equilised. This happens
when:
Pc 1/MPLc
= = (−)Slope of PPF
Pf 1/MPLf

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Actual Production

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Wages and Labor Allocation

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Determining Goods Prices
I As in the Ricardian model, prices depend on the production structure
and consumer demand.
I Why does the relative supply curve look different?

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The Distributional Question

I In each sector the residual value of output after paying for wages is
claimed by the owners of the corresponding specific factor as rents.

I For a given value of MPL, a higher wage implies lower rents.

I Higher wage and higher rents are thus compatible only if the value of
MPL shifts out: workers generate more value for any given amount
of the specific factor.

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Capital and Land Owners

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Changes in the Endowment

I Think of opening to trade with a foreign country.

I So far we have only talked about the France. What about the trade
pattern when we open to trade with Brazil?

I Start with two identical countries: if France and Brazil have the
same endowments, there will be no trade.

I Suppose instead that Brazil has more land but less capital.

I Will be useful to think of how a change in endowment would affect

the home country. Relatively higher K in the France.

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Trade Liberalization

I As in the Ricardian model, trade liberalization promotes import and

export as long as relative prices with trade differ from those with
autarky.
I For example, suppose that with trade, the price of cloth is higher than
under autarky. Say the price of food is the same. Then Pc /Pf is larger
with trade.
I 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.
I An economy exports the good whose relative price has increased and
imports the good whose relative price has decreased.

I The differences between the two relative prices is due to resource

differences across countries.
I For example, the country may be better endowed with capital.
I Can we put in technology into this model?

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Pattern of Trade
I World prices determine the Pattern of Trade.
I Prices in turn depend on the production structure in each economy
(and their demand).
I Why is the world RS curve to the left on the home RS curve?

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Pattern of Trade

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Pattern of Trade

I As Pc has increased, the cloth sector can pay a higher wage.

I Workers move from food to cloth.
I MPLc falls and MPLf rises reducing the differential wage between
cloth and food.
I A new equilibrium is reached when the wage differential is completely
eroded.
I In the new equilibrium there is more labor and hence more output in
cloth than in autarky.
I Food employment and output fall accordingly.

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Goods Prices and Factor Prices

I What are the effects of this reallocation of labor on income

distribution?

I First think of how a change in goods prices affects wages.

I We will use the VMPL graph to determine the new wages.

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Nominal Incomes
I The nominal wage increases, the nominal income of cloth producers
increases, but the nominal income of food producers declines.
I Is this enough for determining the distributional effects of trade
liberalization?

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Real Income of Workers
I The real income of workers can increase or decrease depending on
the importance of cloth in their expenditure.
I Pc ↑> w ↑ but Pf ↔.

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Real Income of Land Owners
I The real income of food producers must decline. Their nominal
income has declined and the price of output has either stayed the
same (food) or increased (cloth).

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Real Income of Capital Owners
I Cloth producers’ real income in terms of cloth faces two conflicting
effects:
I The increase in the output price increases rents.
I The increase in wages reduces rents.

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Rents to Capital Owners
Look at the MPL curve (not the VMPL curve)

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Why Capital Owners Gain from Trade?

I Perfect competition implies all profits are exhausted by wages and

rents.

I Capital owners are also paid their value of marginal product.

I rK = VMPKc = Pc MPKc = Pc FK (K , Lc )

I Since FKL > 0, capital and labor are complementary. As workers

move to the cloth sector, each capital owner has more labor to work
with.

I An increase in Lc raises MPKc , hence rK /Pc rises.

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Determining Real Rents

I It turns out that the first effect (increase in profits) dominates.

I This can be shown by substituting the first order condition (2) into
the profit maximization problem (1) which yields residual profits:

πc = Pc [F (K , Lc ) − FL (K , Lc )Lc ]

Differentiating this yields:

∂(πc /Pc )
= −FLL (K , Lc )Lc > 0
∂Lc

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Gains from Trade

I When goods prices change (from autarky to free trade) some factors
of production lose while others gain in this model.

I Does this mean that trade could on balance be bad for a country?

I Fortunately, the gains for the winners are larger than the losses of
losers and there are therefore aggregate gains from trade.

I As in the Ricardian model, the reason is that trade will allow us to

reach aggregate consumption bundles that are strictly outside our
countries PPF.

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Welfare Gains from Trade

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The Political Economy of Trade

I If a country has relatively more capital, labor is relatively more

productive in cloth, prices for cloth are higher with trade than with
autarky.

I Trade liberalization therefore shifts production from food to cloth

and rents from land owners to capital owners

I Capital owners are in favor of trade liberalization, land owners are

against it.

I Optimal trade policy must weigh one group’s gain against another’s
loss.

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Outline

Introduction

Model

Application

Conclusion

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Application: Migration

I Suppose workers move from Syria to France.

I What happens to prices and real income when the endowment of

labor increases?

I The real wage falls and the real income of both capital and land
increases.

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Outline

Introduction

Model

Application

Conclusion

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Conclusion

I The Specific-Factors model is the second classical trade theory model

that we encounter.

I As in the Ricardian model, trade is due to comparative advantage.

I However, there are two key new insights:

I Comparative advantage can be due to differences in endowments

rather than technology.

I There are aggregate gains from trade, but the gains are unequally
distributed with some factors of production losing and others gaining.

I Factor mobility is key to who gains and who loses.

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