International Economics

Lecture 6: Trade Models II –

The Specific Factors Model

University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Overview

• Introduction

• Setting up the Model

• Distributional effects of a change in price

• Adding trade to the Model

• Conclusions

Slide 1 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Introduction
• The Ricardian Model proved the basics of
comparative advantage, but we need a more
complex model to understand the
distributional effects (effects on income
distribution)

• This is what the Specific Factors Model is for!

Slide 2 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

A bending-outwards PPF: increasing opportunity costs

a Increasing (marginal)
15 b opportunity
cost of capital goods
c
Consumer goods

10 d

5 e

f
0 1 2 3 4 5
Capital goods
Slide 3 The University of Papua New Guinea
 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Setting up the Model

Assumptions:
• Two products (just like in the Ricardian Model)
• But now we have three factors of production
– Can be any three, but convention is to use:
• L: Labour, the mobile, ‘non-specific’ factor
• K: Capital, a fixed and ‘specific’ factor
• T: Land, a fixed ‘specific’ factor

• All labour is employed

• We have perfectly competitive markets

Slide 4 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Setting up the Model

• What is a ‘specific’ factor?

– A factor of production that is specific to a

particular product

– E.g. land for agriculture; or capital for

manufacturing

Slide 5 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Setting up the Model &

An example: cloth and food

• Our two products will be cloth and food

• Food requires land (T); cloth requires capital (K)

• Thus, our production functions are:

– QC = QC(K, LC)

– QF = QF(T, LF)

• Note, we assumed that all labour was employed,

thus: LC + LF = L

Slide 6 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Graphing the production function

Note:
The production
function for food has
a similar shape!

Slide 7 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Setting up the Model &

• Why does the production function have

this shape?
– When the quantity of the specific factor is fixed,
and we increase labour, we expect to see
diminishing returns to labour
– This means that the marginal product of labour
(MPL) eventually decreases, and in fact, would
ultimately become negative!

MPL: The additional output produced by one

additional worker
Slide 8 The University of Papua New Guinea
 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Graphing MPL

Note:
MPL would eventually
become negative!

This is important!
We’ll see why in a few
slides...

Slide 9 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Slide 10 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Setting up the Model &

• Remember we saw that the MPL was equal to the

slope of production function?

• Using the graph from the previous page, we can

calculate that the slope of the PPF is:

– MPLF / MPLC

[Note: It is negative because of the negative slope]

Slide 11 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Setting up the Model &

• Now we know how much of each product

is produced, given how labour is allocated

• But how do we know how labour will be

allocated?

– For that, we need to know how high the

wages are in each of our two sectors…

Slide 12 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Setting up the Model &

• In the Ricardian Model, we assumed that

wages simply reflect the value of the work done

– It is the same for the Specific Factors Model!

• In the Ricardian Model, wages (per hour) were

determined by the price of the product divided by

how many hours it took to produce one unit

– Note: we fixed the quantity produced to one!

Slide 13 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Setting up the Model &

• In the specific factors model, we fix the

number of hours to one, and so it is the quantity
produced that changes

• Thus, if we set out MPL to reflect the value of

one additional (marginal) hour of labour:

w = MPL * P
E.g. wages in the food sector: wF = MPLF * PF

• Except, we assume labour can move freely –

thus wages should be identical in both sectors

Slide 14 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Determining the equilibrium wage...

Note:
The assumption is that
the demand for labour
in each sector is equal
to the value of the
produce of labour
(P * MPL) [which is the
willingness to pay a
certain
Slide 15 level of wage] The University of Papua New Guinea
 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Setting up the Model &

• Looking at wages also helps us another way – it

tells us what the relative prices for our two

products should be

If: MPLC * PC = MPLF * PF = w

Then: – MPLF / MPLC = – PC / PF

• And since we know that – MPLF / MPLC is the

slope of our PPF…

Slide 16 The University of Papua New Guinea
 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

In domestic equilibrium
Eureka!

Slide 17 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Distributional effects of a change in price

• We’ve just established the relationship between

MPL, wages, prices, and the quantities produced

in autarky (an economy without trade)

• But before we add in the trade, let’s see what

happens if we change the domestic prices of cloth

and/or food…

Slide 18 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

A proportionally equal increase in both prices

It just increases the wage

by the same proportion!
Therefore:
• No change to
relative prices
• No change to
Slidethe
19 domestic PPF The University of Papua New Guinea
 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

An increase in one price only (e.g. cloth)

1. Labour shifts
from the food
sector into the
cloth sector...

Slide 20 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

2. ...the
relative price
changes

1. As labour
shifts from the
food sector
into the cloth
sector...

Slide 21 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

The effect on the PPF from an increase

in one price only (e.g. cloth)

2. The relative
price changes

Slide 22 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Distributional effects of a change in price

• In our example, we saw that the absolute wage

increased by less than the increase in the price of

cloth (7% in our example)

– However, it still increased

• But the question is – are workers (L) better off??

Slide 23 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Distributional effects of a change in price

• For this, we need to look at their real wage (w/p)

– That is, how much of the two different products

can they buy? Is it more or less than before?

• Their real wage in terms of cloth has fallen:

– áw (less than 7%) < á PC (7%) => â w/PC

• Their real wage in terms of food has risen:

– áw (less than 7%) > no Δ in PF => á w/PF

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 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Distributional effects of a change in price

• So the effect on workers (L) is ambiguous!

– It depends on what the relative preferences of

workers are for cloth and food...

• What about owners of capital (K) ?

– The price of their product has increased more

than the wage they pay workers

– So they are definitely better off!

Slide 25 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Distributional effects of a change in price

• What about owners of land (T) ?

– The absolute price of their product has not changed…

– …but the wages they must pay have increased

– So they are definitely worse off!

• And can show all of these distributional effects

diagrammatically!

Slide 26 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Distribution of income: consumer and producer surplus

Consumer Demand
surplus curve for
Labour

Producer
surplus

Slide 27 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Distribution of income: consumer and producer surplus

Note:
The effect on total wages [red]
paid [blue] is ambiguous:
(w/PC)1 * L1C => (w/PC)2 * L2C

It depends!

Slide 28 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Adding trade to the Model

• Finally, let’s add the trade to our Model !

• Instead of considering two economies, we only look

at ‘Home’ and assume that they face a world price

• To do this, we again use general equilibrium analysis:

– Relative demand (RD) & relative supply (RS)

• Except we assume that producers are indifferent who

they supply to…

– So there is only the one RD with trade: RDWorld

Slide 29 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

But first: RD and RS in autarky

Slide 30 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Note: In this example, the world relative

...and now with trade price of cloth just happens to be higher

This is only an assumption!

But it is true that there is
World
Slide 31 only one RD The University of Papua New Guinea
 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Opening up to trade leads to a changes in

Home’s relative price!

We can then track the effects from this

change in relative price just like we did
before (Slides 20 – 28)

Note: In all our examples we tracked an

increase in the relative price of cloth
Slide 32 The University of Papua New Guinea
 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Proving gains from trade

Slide 33 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Conclusions
• The Specific Factors Model is very useful in
determining the winners and losers from trade
• Trade benefits the factor that is specific to
the export market, but hurts the factor that
is specific to the import market
• The effects upon the non-specific factor are
ambiguous
• It gives us a some understanding of how resource
endowments – the stock of specific factors (i.e. K, T)
and non-specific factors (i.e. L) – affect trade

Slide 34 The University of Papua New Guinea

 Lecture 6: Trade Models II – The Specific Factors Model Michael Cornish

Conclusions
• However, it still doesn’t tell us exactly how

differences in resource endowments are a

cause of trade

• For that we need our next trade model:

The Heckscher-Ohlin Model

» So stay tuned!

Slide 35 The University of Papua New Guinea