Gains and Losses from Trade

3
in the Specific-Factors Model

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

Answer: It is a short-run model because land and capital are specific to a particular
sector and only labor is mobile between the sectors.
2. Figure 3-7 presents wages in the manufacturing and services sectors for the period
1973 to 2009. Is the difference in wages across sectors consistent with either the
Ricardian model studied in Chapter 2 or the specific-factors model? Explain why or
why not.
Answer: The difference in wages across the sectors implies that the theoretical as-
sumption of equalized earnings between the different industries is a simplification of
the Ricardian and specific-factors models.
3. In the gains from trade diagram (Figure 3-3), suppose that instead of having a rise in
the relative price of manufactures, there is a fall in that relative price.
a. Starting at the autarky point A in Figure 3-3, show what would happen to pro-
duction and consumption.
Answer: U2
Output of agriculture, QA

C
A

U1

Output of manufacturing, QM

S-19
S-20 Solutions ■ Chapter 3 Gains and Losses from Trade in the Specific-Factors Model

As seen in the previous diagram, a fall in the relative price of manufactures is

shown by the smaller slope (in absolute value) of the international price line. The
country produces at point B, at which the international price line intersects its
PPF. The higher relative price of agriculture attracts workers into that sector
such that the output of agriculture increases and the output of manufactured
goods decreases. Now the highest level of utility is achieved where the highest
possible indifference curve intersects with the new price line (at C). The increase
in utility signified by the higher indifference curve is a measure of gains from
trade.
b. Which good is exported and which is imported?
Answer: The decrease in the relative price of manufactures in the trade equilib-
rium (compared with autarky) also means that the country is importing manu-
factured goods and exporting agricultural goods.
c. Explain why the overall gains from trade are still positive.
Answer: Overall gains from trade are still positive because the country is able to
sell agriculture at a higher price and buy manufactured goods at a lower price
than it could have in autarky. The fact that the relative price (of manufactured
goods) fell with trade indicates that the foreign country’s autarky relative price
was lower. That is, in this case the country has a comparative advantage in agri-
culture. In Figure 3-4, the case illustrated is one in which the country has a com-
parative advantage in manufacturing goods and thus their export leads to an in-
crease in their relative price.
4. Starting from equilibrium in the specific-factors model, suppose the price of manu-
factured goods falls so that wages fall from W  to W in Figure 3-5.
a. Show that the percentage fall in wages is less than the percentage fall in the price
of manufacturing, so that the real wage of labor in terms of manufactured goods
goes up.
Answer:
Wage

PM · MPLM

W
PM · MPLM

PM · MPL

0M LM L L LA 0A


L

As seen in the diagram, both the price of manufactured goods and the wages de-
crease. The key to this exercise is to realize that the vertical distance of the de-
crease in wage is less than the vertical distance of PM  MPLM. Therefore:

PM  MPLM  W
 Solutions ■ Chapter 3 Gains and Losses from Trade in the Specific-Factors Model S-21

where W represents the change in wage. Dividing both sides by the initial
wage (W´  P´M  MPLM):

PM / P´M  W / W´
This is the desired result: the percentage fall in the wage is less than the percent-
age fall in the price of manufacturing, so that the real wage of labor in terms of
manufactured goods goes up.
b. What happens to the real wage of labor in terms of agriculture?
Answer: Because the wage decreases and the price of agricultural goods remains
the same, the amount of agricultural goods that can be bought by labor de-
creases. That is, real wage decreases in terms of agriculture.
c. Are workers better off, worse off, or is the outcome ambiguous?
Answer: Because the real wage increases with respect to manufactured goods
and decreases with respect to agriculture, the outcome will be ambiguous for
workers. For some, who prefer to purchase a lot of agriculture, the price change
means an overall loss in terms of how much they can buy. Others, who prefer
to buy mainly manufactured goods, gain in terms of how much they can buy.
5. Use the following information to answer the questions below:

Manufacturing: Sales revenue  PM  QM  150

Payments to labor  W  LM  100
Payments to capital  RK  K  50

Agriculture: Sales revenue  PA  QA  150

Payments to labor  W  LA  50
Payments to land  RT  T  100
Holding the price of manufacturing constant, suppose the increase in the price of
agriculture is 10% and the increase in the wage is 5%.
a. Determine the impact of the increase in the price of agriculture on the rental on
land and the rental on capital.
Answer: Rental on land can be calculated as follows:

R T (PA / PA)  PA  QA  (W / W)  W  LA

_  
RT RT  T

R T 10%  150  5%  50%

_    12. 5%
RT 100
Recalling that the price of manufacturing remained constant, we get the rental
on capital as

0  QM  W  LM
RK  
K
RK – W W  LM
  _ 
RK 冢
W RK  K 冣
RK
冢 冣
100
  5%    10%.
RK 50
S-22 Solutions ■ Chapter 3 Gains and Losses from Trade in the Specific-Factors Model

b. Explain what has happened to the real rental on land and the real rental on
capital.
Answer: Because of the 10% increase in the price of agriculture, the real rental
on land rose whereas the real rental on capital fell. Therefore, landowners are bet-
ter off because the percentage increase in the rental on land is greater than the
percentage increase in the price of agriculture, whereas the price of manufacture
is constant. Capital owners are worse off in terms of their ability to purchase
both manufacture and agriculture because the rental to capital has fallen.

RK / RK 0 W / W PA / PA RT / RT, for an increase in PA

⎧
⎪
⎪
⎨
⎪
⎪
⎩

⎧
⎪
⎪
⎨
⎪
⎪
⎩

⎧
⎪
⎪
⎨
⎪
⎪
⎩
Real rental Change in the real Real rental
on capital falls wage is ambiguous on land rises

6. If, instead of the situation given in problem 5, the price of manufacturing was to fall
by 10%, would landowners or capital owners be better off? Explain. How would the
decrease in the price of manufacturing affect labor? Explain.
Answer: Assuming that the decrease in the price of manufactures leads to a fall in
wage by 5%, capital owners would be worse off because the rental on capital would
decrease (20%) more than the drop in the price of manufacturing (10%). Landown-
ers would be better off as the rental on land rises (10%). The effect on labor is am-
biguous because although the percentage of wage decrease is less than the percentage
fall in price of manufacturing, labor loses in terms of their availability to purchase
agriculture.
The rental on capital is found by calculating the following:

RK (PM / PM)  PM  QM  (W / W )  W  LM

  
RK RK  K

RK 10%  150 5%  100

    20%
RK 50
although the rental on land is

0  QA  W  LA
RT  —
T
RT W W  LA
   
RT W RT  T 冢 冣
RT
冢 冣
50
  5%    2. 5%.
RT 100
Putting it together we get

RK / RK PM / PM W / W 0 RT / RT, for a decrease in PM.

⎧
⎪
⎪
⎨
⎪
⎪
⎩

⎧
⎪
⎪
⎨
⎪
⎪
⎩

⎧
⎪
⎪
⎨
⎪
⎪
⎩

Real rental Change in the real Real rental

on capital falls wage is ambiguous on land rises
 Solutions ■ Chapter 3 Gains and Losses from Trade in the Specific-Factors Model S-23

7. Read the article by Lori G. Kletzer and Robert E. Litan, “A Prescription to Relieve
Worker Anxiety,” Policy Brief 01-2, Institute for International Economics, Washing-
ton, DC, http://www. iie. com/publications/pb/Pb01-2. htm, which refers to the
U. S. recession of 2000–2001. Then answer the following questions.
a. Under the most recent version of Trade Adjustment Assistance (TAA) in the
United States that they refer to, how many extra weeks of unemployment insur-
ance (UI) are workers eligible for? What two criteria must they meet to qualify
for this extra unemployment insurance?
Answer: “Under the most recent version of the Trade Adjustment Assistance
(TAA) Act, qualified workers may gain an additional 52 weeks of UI payments,
provided they are enrolled in an approved training program. A similar program,
the North American Free Trade Agreement Transitional Adjustment Assistance
(NAFTA-TAA) program, was created in 1993. For eligibility, workers must
prove that they lost their job because of increased imports from, or a shift in pro-
duction to, either Canada or Mexico. ”
b. Consider the proposal for “wage insurance” that Kletzer and Litan make in their
article. What criteria would a worker need to meet to qualify for this insurance?
What amount of extra income would they receive from the insurance?
Answer: “Wage insurance would work as follows: Eligible workers would re-
ceive some fraction of their wage loss, which could vary by age and tenure of the
worker for up to 2 years following the initial date of job loss, but would begin
to be paid only when workers found a new job. ”
“To qualify for our proposed supplemental wage insurance benefit, workers need
only document that they have been ‘displaced’ according to criteria similar to the
operational definition of displacement used by the BLS in its Displaced Worker
Surveys (plant or company closed or moved, elimination of position or shift, in-
sufficient work); that they had served at their previous job for a minimum period
of time: we suggest 2 years; and that they have suffered an earnings loss (from old
job to new job) . . . ”
c. If Kletzer and Litan’s new plan for “wage insurance” had been adopted by the
United States, what would have been the budgetary cost in 1999 when unem-
ployment was 4. 2%? How does this compare with the amount that is now spent
on unemployment insurance?
Answer: “Assuming a 50% replacement and subsidy rate, the table indicates that
our wage insurance and health insurance program would have cost about $2. 9
billion in 1999, when the national unemployment rate averaged 4. 2%.
“The total cost, less than $4 billion, might have been a major obstacle when fed-
eral deficits were high and growing but is not a problem now, and in any event
would be small in relation to the more than $20 billion that is now spent on un-
employment insurance . . . ”
8. In the specific-factors model, assume that the price of agricultural goods de-
creases whereas the price of manufactured goods is unchanged (PA / PA 0 and
PM / PM  0). Arrange the following terms in ascending order:

RT / RT RK / RK PA / PA PM / PM W / W

Hint: Try starting with a diagram such as Figure 3-6 but change the price of agricul-
tural goods instead.
Answer: It helps to separate this exercise into two parts. The first part is to arrange
the percentage changes in wages and goods prices. This part is similar to problem 4
except that now it is the price of agriculture that is decreasing. By similar logic, the
S-24 Solutions ■ Chapter 3 Gains and Losses from Trade in the Specific-Factors Model

percentage change in price of agricultural goods is larger than the percentage change
in wage, which in turn is larger than the percentage change in the price of manufac-
tured goods (zero). Thus,

0  PM / PM W / W PA / PA
For the second part, adding the percentage changes in specific-factors rental rates, re-
call that in this model, although the real return to labor is ambiguous (which means
that more agricultural products but fewer manufactured goods can be purchased by
labor), the real return to capital and land can both be determined and move in op-
posite directions. The general rule for the specific-factors model is that a decrease in
the relative price of an industry leads to a real loss of the factor specific in that in-
dustry, and a real return to the specific factor in the other industry. This means that
the percentage change in losses to land is greater than both price changes and that the
percentage change in returns to capital is greater than both price changes, which is
equivalent to saying that fewer of both goods can be purchased by landowners al-
though more of both goods can be purchased by capital owners, respectively.

RT / RT PA / PA W / W PM / PM RK / RK

9. Suppose two countries, Canada and Mexico, produce two goods, timber and televi-
sions. Assume that land is specific to timber, capital is specific to televisions, and la-
bor is free to move between the two industries. When Canada and Mexico engage
in free trade, the relative price of televisions falls in Canada and the relative price of
timber falls in Mexico.
a. In a graph similar to Figure 3-5, show how the wage changes in Canada because
of a fall in the price of televisions, holding constant the price of timber. Can we
predict that change in the real wage?
Answer: As shown by the following figure, real wage falls but by less than the
percentage decrease in the price of televisions.

Vertical distance
Wage PTV · (MPLTV )

PTIM · MPLTIM

A
W
PTV · MPLTV

W
B
PTV  · MPLTV

W

0TV LTV L L LTIM 0TIM


L

Labor
 Solutions ■ Chapter 3 Gains and Losses from Trade in the Specific-Factors Model S-25

b. What is the impact of opening trade on the rentals on capital and land in Canada?
Can we predict that change in the real rentals on capital and land?
Answer: Because capital is specific to the television sector, the drop in the rela-
tive price of televisions will lead to a fall in the rental on capital. With Canada
exporting timber, rental on land will rise because land is specific to the timber
industry.
c. What is the impact of opening trade on the rentals on capital and land in
Mexico? Can we predict that change in the real rentals on capital and land?
Answer: Through the exports of televisions, the relative price of televisions will
rise in Mexico, which will lead to an increase in the rental on capital. By con-
trast, the rental on land will fall.
d. In each country, has the specific factor in the export industry gained or lost, and
has the specific factor in the import industry gained or lost?
Answer: In both cases, the specific factor in the export industry (i. e. , land in
Canada and capital in Mexico) gained whereas the factor specified to the import
industry (i. e. , capital in Canada and land in Mexico) loses when the two coun-
tries engage in trade.
10. Home produces two goods, computers and wheat, where capital is specific to com-
puters, land is specific to wheat, and labor is mobile between the two industries.
Home has 100 workers and 100 units of capital, but only 10 units of land.
a. Draw a graph similar to Figure 3-1, with the output of wheat on the vertical axis
and the labor in wheat on the horizontal axis. What is the relationship between
the output of wheat and the marginal product of labor in the wheat industry as
more labor is used?
Answer: See the following graph.
Wheat output, QW

MPLW
1

Labor in wheat, LW

As more labor is added to the production of wheat, the marginal product of la-
bor declines so that although the output of wheat continues to increase, the out-
put is increasing at a decreasing rate.
S-26 Solutions ■ Chapter 3 Gains and Losses from Trade in the Specific-Factors Model

b. Draw the production possibilities frontier (PPF) for Home with wheat on the
horizontal axis and computers on the vertical axis.
Answer: See the following graph.
Computer
output, QC

Slope   (MPLC / MPLW )

MPLC B
MPLW

Production possibilities
frontier, PPF

Wheat output, Q
W

c. Explain how the price of wheat relative to computers is determined in the ab-
sence of trade.
Answer: In the absence of international trade, the relative price of wheat is the
slope of the line tangent to the PPF and Home’s indifference curve.
d. Reproduce Figure 3-5 with the amount of labor used in wheat measuring from
left to right along the horizontal axis, and the amount of labor used in comput-
ers moving in the reverse direction.
Answer: See graph below.
Labor
market Value of
equilibrium marginal product
Wage of computer
PC · MPLC

Value of
marginal product
of wheat
A
W

PW · MPLW

0W LW L LC 0C

Wheat labor Computer

labor
 Solutions ■ Chapter 3 Gains and Losses from Trade in the Specific-Factors Model S-27

e. Assume that because of international trade, the price of wheat rises. Analyze the
effect of the increase in the price of wheat on the allocation of labor between
the two sectors.
Answer:
Vertical
distance

PW · (MPLW )
Wage

B
W
W
W P´W · MPLW
A

PW · MPLW

0W LW L L LC 0C


L

Wheat labor Computer

labor

The increase in the price of wheat shifts the PW  MPLW curve upward to PW' 
MPLW so that the new equilibrium is at point B. The amount of labor used in
wheat increases from 0WL to 0WL', although the amount of labor devoted to
computers decreases from 0CL to 0CL'. Although the wage rises from W to W ',
the increase is less than the vertical shift of the PW  MPLW curve given as
PW  MPLW.
11. Similar to Home in problem 10, Foreign also produces computers and wheat using
capital, which is specific to computers; land, which is specific to wheat; and labor,
which is mobile between the two sectors. Foreign has 100 workers and 100 units of
land, but only 10 units of capital. It has the same production functions as at Home.
a. Will the no-trade relative price of wheat be higher in Home or in Foreign? Ex-
plain why you expect this outcome.
Answer: The no-trade relative price of wheat will be higher in Home than For-
eign because Foreign has more units of land relative to Home. In other words,
with more capital available for labor than land, the marginal product of labor in
wheat is lower than the marginal product of capital in computers at Home. Be-
cause wages are equalized across the sector, price must be higher in the wheat
industry:

PW  MPLW  PC  MPLC
The situation would be opposite for the foreign country, which has more land
than capital. In this case, the price of capital is higher relative to the price of
wheat without trade.
S-28 Solutions ■ Chapter 3 Gains and Losses from Trade in the Specific-Factors Model

Computer
output, Q *C

Slope   ( MPL *C / MPL *W )

MPL *C B

MPL*W

Production possibilities
frontier, PPF

Wheat output, Q *W

b. When trade is opened, what happens to the relative price of wheat in Foreign
and to the relative price of wheat in Home?
Answer: When the two countries engage in trade, Home will export comput-
ers so that the relative price of wheat decreases at Home, whereas Foreign will
export wheat, which will increase the relative price of wheat in Foreign.
c. Based on your answer to (b), predict the effect of opening trade on the rental on
land in each country, which is specific to wheat. What about the rental on cap-
ital, which is specific to computers?
Answer: With Home exporting computers, the rental on capital will increase
while the rental on land will decrease. Because Foreign exports wheat, landown-
ers will experience an increase in the rental on land, whereas capital owners will
lose because of the decrease in the rental on capital.
12. In the text, we learned that workers displaced by import competition are eligible for
compensation through the Trade Adjustment Assistance (TAA) program. In addition
to workers, firms are also eligible for support through Trade Adjustment Assistance for
Firms, a federal program that provides financial assistance to manufacturers affected
by import competition. Go to www. taacenters. org to read about this program, and
answer the following questions:
a. What criteria does a firm have to satisfy to quality for benefits?
Answer: According to the website, manufacturers are qualified to receive bene-
fits from the TAA if imports have contributed to declines in their employment
and sales or production.
b. What amount of money is provided to firms and for what purpose?
Answer: Under the “50/50 cost sharing” program, the TAA pays up to $75,000
for projects to improve a manufacturer’s competitiveness. The funds go toward
the cost of hiring industry experts, including consultants, engineers, and design-
ers for projects.
 Solutions ■ Chapter 3 Gains and Losses from Trade in the Specific-Factors Model S-29

c. Provide an argument for and an argument against the continued funding of this
federal program.
Answer: Opponents of TAA would argue that the program is costly. The fol-
lowing figure shows the total expenditures of the program from 1995 to 1999,
where more than half of the cost is administrative and operations related. Pro-
ponents of TAA would draw on the positive effect the assistance program has on
the manufacturing industry and local economy.

Trade adjustment assistance centers’ total expenditures, cooperative agreement years 1995-99

$6,000,000

$5,000,000

$4,000,000

$3,000,000

$2,000,000

$1,000,000

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Operations and administrative costs Consultant costs

Note: Operations and administrative costs include staff time spent assisting
firms with the certification process and preparing adjustment plans,
in addition to the cost of funding day-to-day operations.
Source: GAO derived from TAA Centers’ data.