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Introduction 
Ricardian: suggests all countries gain from trade:
‡ Moreover: every individual is better off 

Trade has substantial effects on the income 

distribution within each trading nation. There are two main reasons why international trade has strong effects on the distribution of income:

‡ Resources cannot move immediately or costlessly ‡
from one industry to another. Industries differ in the factors of production they demand.
Econ 355 

The specific factors model allows trade to affect
income distribution.

The Specific Factors Model 
Assumptions of the Model
‡ Assume that we are dealing with one economy that can produce ‡ ‡ ‡ ‡ ‡ ‡
two goods, manufactures and food. There are three factors of production; labor (L), capital (K) and land (T ). Manufactures are produced using capital and labor (but not land). Food is produced using land and labor (but not capital). Labor is therefore a mobile factor that can be used in either sector. Land and capital are both specific factors that can be used only in the production of one good. Perfect Competition prevails in all markets.
Econ 355

Technology

Econ 355

How much of each good does the economy produce? ‡ The production function for manufactures is given by QM = QM (K. LM) where: ± QM is the economy¶s output of manufactures ± K is the economy¶s capital stock ± LM is the labor force employed in manufactures (3-1) ‡ The production function for food is given by QF = QF (T. LF) where: ± QF is the economy¶s output of food ± T is the economy¶s supply of land Econ 355 ± LF is the labor force employed in food (3-2) .

The Specific Factors Model Figure 3-1: The Production Function for Manufactures Output. LM Econ 355 . QM QM = QM (K. LM) Labor input.

‡ Marginal product of labor is the increase in output that corresponds to an extra unit of labor. ± Therefore. each additional unit of labor will add less to the production of output than the last. Econ 355 . ± Adding one worker to the production process (without increasing the amount of capital) means that each worker has less capital to work with.The Specific Factors Model ‡ The shape of the production function reflects the law of diminishing marginal returns.

The Specific Factors Model Figure 3-2: The Marginal Product of Labor Marginal product of labor. LM Econ 355 . MPLM MPLM Labor input.

 Production Possibilities ‡ To analyze the economy¶s production possibilities. Econ 355 . we need only to ask how the economy¶s mix of output changes as labor is shifted from one sector to the other.The Specific Factors Model ‡ The full employment of labor condition requires that the economy-wide supply of labor must equal the labor employed in food plus the labor employed in manufactures: LM + LF = L (3-3) ‡ We can use these equations and derive the production possibilities frontier of the economy.

Econ 355 LM (increasing ) . LF) Output of food. QM (increasing ) Production function for manufactures QM =QM(K. QF (increasing ) 1' 2' 3' Labor input in food. LF (increasing ) L2F 1 2 Economy¶s allocation of labor (AA) 3 AA L2M Q2M Output of manufactures.The Specific Factors Model Figure 3-3: The Production Possibility Frontier in the Specific Factors Model Production function for food QF =QF(T. LM) Economy¶s production possibility frontier (PP) Q2F PP Labor input in manufactures.

The Specific Factors Model Figure 3-1: The Production Possibility Frontier Output. Q Econ 355 . Q Slope of the PPF: -MPLF/MPLM Output.

Labour Marker Econ 355 .

Wages.The Specific Factors Model  Prices. Econ 355 . profit-maximizing employers will demand labor up to the point where the value produced by an additional person-hour equals the cost of employing that hour. ‡ Demand for labor: ± In each sector. and Labor Allocation ± To answer the above question we need to look at supply and demand in the labor market.

w=VMPL ‡ The demand curve for labor -food sector : MPLF x PF = w ± The wage rate equals the value of the marginal product of labor in food. (3-5) Econ 355 .manufacturing sector : MPLM x PM = w (3-4) ± The wage equals the value of the marginal product of labor in manufacturing.How much labor will be employed in each sector?.Demand Curve ‡ The demand curve for labor .

 The wage rate is determined by the requirement that total labor demand equal total labor supply: LM + LF = L Econ 355 (3-6) . because of the assumption that labor is freely mobile between sectors.The Specific Factors Model  The wage rate must be the same in both sectors.

L Labor used in food. W/ VMP (m) Wage rate.The Specific Factors Model Figure 3-4: The Allocation of Labor Wage rate. LF . W/ VMP (F) 1 W1 PF X MPLF (Demand curve for labor in food) PM X MPLM (Demand curve for labor in manufacturing) Labor used in manufactures. LM L1M L1F Econ 355 Total labor supply.

Relationship between relative prices and output:  MPLM x  MPLM x PM = w. Econ 355 . MPLF x PF = w PM = MPLF x PF  -MPLF/MPLM = -PM/PF  At the production point the production possibility frontier must be tangent to a line whose slope is minus the price of manufactures divided by that of food.

Equilibrium in the Economy Econ 355 .

QF Slope = -(PM /PF)1 Q1F 1 PP Q1M Output of manufactures. QM Econ 355 .The Specific Factors Model Figure 3-5: Production in the Specific Factors Model Output of food.

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The Specific Factors Model ‡ What happens to the allocation of labor and the distribution of income when the prices of food and manufactures change? ‡ Two cases: ± An equal proportional change in prices ± A change in relative prices Econ 355 .

LM Econ 355 Labor used in food. LF . W PM 1 X MPLM W2 10% wage increase PM X MPLM PM increases 10% 2 PF 2 X MPLF Wage rate. W 2 PF increases 10% PF 1 X MPLF 1 W1 Labor used in manufactures.The Specific Factors Model Figure 3-6: An Equal Proportional Increase in the Prices of Manufactures and Food Wage rate.

no real changes occur. so real wages (i. ± The wage rate (w) rises in the same proportion as the prices. the ratios of the wage rate to the prices of goods) are unaffected. Econ 355 . ± The real incomes of capital owners and landowners also remain the same.The Specific Factors Model ‡ When both prices change in the same proportion.e.

W 2 1 PM 2 X MPLM PM 1 X MPLM Wage W2 rate rises by W 1 less than 7% Labor used in manufactures.The Specific Factors Model Figure 3-7: A Rise in the Price of Manufactures Wage rate. W 7% upward shift in labor demand PF X MPLF 1 Wage rate. LF . LM Amount of labor shifted from food Econ 355 to manufactures Labor used in food.

The Specific Factors Model ‡ When only PM rises. ‡ The wage rate (w) does not rise as much as PM since manufacturing employment increases and thus the marginal product of labor in that sector falls. labor shifts from the food sector to the manufacturing sector and the output of manufactures rises while that of food falls. Econ 355 .

(PM /PF)1 Q1F 1 Q2F 2 Slope = . QF Figure 3-8: The Response of Output to a Change in the Relative Price of Manufactures Slope = .The Specific Factors Model Output of food.(PM /PF) 2 PP Q1M 2 QEcon 355 M Output of manufactures. QM .

The Specific Factors Model   Relative Prices and the Distribution of Income ‡ Suppose that PM increases by 10%. ‡ Owners of capital: ± They are definitely better off. we would expect the wage to rise by less than 10%. this depends on the relative importance of manufactures and food in workers¶ consumption. say by 5%. Econ 355 . Then. What is the economic effect of this price increase on the incomes of the following three groups? ‡ Workers: ± We cannot say whether workers are better or worse off. ‡ Landowners: ± They are definitely worse off.

Appendix: Further Details on Specific Factors The Distribution of Income Within the Manufacturing Sector Marginal Product of Labor. LM Econ 355 . MPLM Income of capitalists w/PM Wages MPLM Labor input.

LM Econ 355 .Appendix: Further Details on Specific Factors A Rise in PM Benefits the Owners of Capital Marginal Product of Labor. MPLM Increase in capitalists¶ income (w/PM)1 (w/PM)2 MPLM Labor input.

MPLF Decline in landowners¶ income (w/PF)2 (w/PF)1 MPLF Labor input. LF Econ 355 .Appendix: Further Details on Specific Factors A Rise in PM Hurts Landowners Marginal Product of Labor.

Trade Between two countries Econ 355 .

the only source of international trade is the differences in relative supply. land. The relative supply might differ because the countries could differ in: ± Technology ± Factors of production (capital. Therefore. labor) Econ 355 .International Trade in the Specific Factors Model  Assumptions of the model ‡ Assume that both countries (Japan and America) have ‡ the same relative demand curve.

International Trade in the Specific Factors Model Figure 3-10: Changing the Capital Stock Wage rate. LM Amount of labor Econ 355 shifted from food to manufactures Labor used in food. W Increase in capital stock. W 2 W2 1 W1 PM X MPLM2 PM X MPLM1 Labor used in manufactures. LF . K PF 1 X MPLF Wage rate.

QF Q1F Q2 F 1 2 PPF ±biased shift to the right (high K) PP Econ Q1M 355 Q2M Output of manufactures.Another way of looking at this Output of food. QM .

± Given that the demand is the same in both the countries Differences in supply of the two goods lead to difference in relative prices. ± As a result.International Trade in the Specific Factors Model  Trade and Relative Prices ‡ Suppose that Japan has more capital per worker than America. Econ 355 . the pretrade relative price of manufactures in Japan is lower than the pretrade relative price in America. while America has more land per worker than Japan.

QM/QF Econ 355 .International Trade in the Specific Factors Model Figure 3-11: Trade and Relative Prices Relative price of manufactures. PM /PF RSA RSWORLD (PM /PF )A (PM /PF )W (PM /PF )J RDWORLD RSJ Relative quantity of manufactures.

Econ 355 . although both outputs increase.International Trade in the Specific Factors Model Comparative Analysis: ‡ An increase in the supply of capital would shift the relative supply curve to the right. ‡ What about the effect of an increase in the labor force? ± The effect on relative output is ambiguous. (or) for a country with higher K the relative ss curve for Manufacturing would be to the right. (or) for a country with higher L the relative ss curve for Manufacturing would be to the left. ‡ An increase in the supply of land would shift the relative supply curve to the left.

Econ 355 .International Trade in the Specific Factors Model  The Pattern of Trade ‡ In a country that cannot trade. the output of a good ‡ ‡ ‡ must equal its consumption. A country cannot spend more than it earns. Budget Constraint:. International trade makes it possible for the mix of manufactures and food consumed to differ from the mix produced.

QF Budget constraint (slope = -PM/PF) 2 Q2F Production possibility curve Q2M Consumption of manufactures.International Trade in the Specific Factors Model Figure 3-12: The Budget Constraint for a Trading Economy (Japan) Consumption of food. DF Output of food. DM Output of manufactures. QM Econ 355 .

QF Japan Import 2 Q1F 1.PM/PF) PP Q1M Econ 355 Consumption of manufactures. DF Output of food. DM Output of manufactures.After Trade Budget constraint (slope = .Income Distribution and the Gains from Trade Figure 3-14: Trade Expands the Economy¶s Consumption Possibilities Consumption of food. QM .

International Trade in the Specific Factors Model Figure 3-13: Trading Equilibrium Quantity of food Quantity of food American budget constraint Japanese budget constraint America¶s QA F food A exports D F Japan¶s DJ F food imports QJF Japan¶s manufactures exports DJM QJM Quantity of manufactures QAM DAM America¶s manufactures imports Quantity of manufactures Econ 355 .

‡ In the specific factors model. factors specific to export sectors in each country gain from trade. ‡ In this model. differences in resources can cause countries to have different relative supply curves. while factors specific to importcompeting sectors lose.  The fundamental reason why trade potentially benefits a country is that it expands the economy¶s choices.Income Distribution and the Gains from Trade  A useful model of income distribution effects of international trade is the specific-factors model. ‡ This expansion of choice means that it is always possible to redistribute income in such a way that everyone gains from trade. and thus cause international trade. Econ 355 . ‡ Mobile factors that can work in either sector may either gain or lose.

 Income distribution effects arise for two reasons: ‡ Factors of production cannot move instantaneously ‡ and costlessly from one industry to another.Summary  International trade often has strong effects on the distribution of income within countries. Econ 355 . Changes in an economy¶s output mix have differential effects on the demand for different factors of production. so that it often produces losers as well as winners.