# Trade and Factor Prices Factor Price Equalization.

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Trade and Factor Prices Factor Price Equalization

Trade and Input prices Stolper-Samuelson Theorem As a result of trade in each country: The production of the good in which the country has a comparative advantage would increase Under the H-O assumptions, the production of the good that uses the countrys abundant resource would increase, increasing the demand for that resource (as well as the demand for the scarce resource, but proportionally less)while the production of the good that uses the countrys scarce resource would decrease, releasing both scarce and abundant resources

Production Adjustments As the production of the good using the abundant resource intensively increases, demand for that resource will increase; so will the demand for the scarce resource, but by a smaller amount As the production of the good that uses the scarce resource intensively decreases, both abundant and scarce resources will be released, but relatively more of the scarce resource will be released than the abundant resource

Factor Markets Labor Capital SLSL SKSK Do D1 D2 D1 D2 Do Wo W2 ro r2 0 0 KL

Stolper-Samuelson Theorem A change in the price of a (traded) good results in a more than proportional change, in the same direction, in the price of the factor that is used in the production of that good more intensively; a labor-abundant country specializing (and exporting) the labor intensive good will see an increase in its wages proportionally more than the increase in the relative price of the labor intensive good.

As a result of trade: under the H-O assumptions, The price of the abundant factor will increase proportionally more than the increase in the price of the good that uses the abundant factor intensively: that results in an increase in the real wages in the labor- abundant country. The price of the scarce resource will decrease proportionally more than the decline the relative price of the good that uses the scarce resource intensively: a decrease in the real price of the scarce resource; the rental price of capital in the capital-poor country will decrease: W A W B r A r B

Factor Price Equalization A Simple Approach

A One-Input World Recall that (in a Ricardian world): P A = a A. W A P B = a B. W B If P A = P B ==> a A. W A = a B. W B If a A = a B ==> W A = W B By the same token: If the labor in Country A is twice as productive as the labor in Country B, then: 2a A = a B W A = 2 W B

Trade and Factor Prices in a Ricardian World In a Ricardian world where relative prices are determined by the (relative) labor content of each unit of a good, and trade is driven by relative price differentials (comparative advantage), after trade, the higher relative price of the good a country specializes in would result in higher (real) wages for all. Therefore, one would expect free trade to be supported by all.

A Two-Factor H-O World In each country: L = a LX. X + a LY. Y K = a KX.X + a KY Y Recall: a L = 1/MPL ; a K = 1/MPK (P) A = MC = a LXA. W + a KXA. r (P) B = MC = a LXB. W + a KXB. r For any traded good: Assuming fixed proportion production functions for both goods we write:

A simple demonstration: Consider a country with capital and labor producing X and Y where Px = Py = 2; Px/Py = 2/2 = 1 Px = w + r; (K/L)x = 1 Py = 0.5 w + 1.5 r ; (K/L)y = 3 Note that X is relatively more labor intensive Solving 2 = w + r and 2 = 0.5 w + 1.5 r for w and r, well get: w = r = 1; w/r = 1 Now suppose Px =2.2 (A 10% increase in the price of X) This time we solve 2.2 = w + r and 2 = 0.5 w + 1.5 r for w and r. well get: w = 1.30 (30% increase in wage); r = 0.90 (10% reduction) Now: w/r = 1.30/0.90 = 1.44 (44% increase)

Starting with K and L and goods X and Y: Where (Px/Py) A r B Note that Country A is labor-abundant Good X is labor intensive After trade: (Px/Py) A ; (Px/Py) B Demand for labor in A will increase while the production tends toward X and away from Y In A wage, W A, will increase while r A will go down In B wage, W B, will decrease while r B will go up (Px/Py) A = (Px/Py) B = tt W A = W B ; r A = r B

In each country: As w/r ration changes, changing the slope of the isoquant, the K/L ratio changes o L K -(w/r) 1 -(w/r)o (K/L) 1 (K/L)o MRTS = MPL/MPK= w/r Qx

Trade as an Alternative to Factor Movements Note: assuming the basic assumptions of the H-O model hold, still complete output price equalization may not occur due to transportation costs, barriers to trade, and existence of goods that are rarely traded. Yet, the factor price equalization theorem suggests an important policy alternative:Allow free trade in outputs, specialize in labor-intensive production, and export labor indirectly in the form of labor-intensive goods. In recent years countries such as Ireland, the Philippines, India, Jamaica, and Bangladesh, China, and Malaysia have been doing just just that.

Factor Immobility So far we have been assuming that factors are completely mobile among industries within a country and completely immobile among countries. At least in the short run within each country the mobility of factors may be imperfect. Thus, the short-run effects of (free) trade may not be the same long-run effects explained by Stolper- Samuelson and factor price equalization theorem.

Total Labor wo o Wage Rug Inds Wage Comp.Inds D LRo : VMP LRo D LC : VMP LC The Case of Short-Run Labor Immobility D LR1 : VMP LR1 Rug Labor w1w1 w2w2 w2w2

Recall that in factor markets Wage = w = MPL. Price = Value of Marginal Product of Labor (The demand for labor originates from this equation) Likewise, Capital rent = r = MPK. Price = Value of Marginal Product of Capital (The demand for capital originates from this equation.) An increase in the price (of a good) would make demand for the input used in the production (of that good) increase (shift).

The Effect of Price on factor prices when one of the Factors is Immobile Assuming labor is mobile but capital is immobile, wage rates rise in both industries, but by proportionally less than the price of shoes. –The effect on workers purchasing power depends on shares of shoes and computers in workers consumption baskets. The return to shoe capital rises more than the price of shoes, so owners of shoe capital enjoy an increase in buying power regardless of their pattern of consumption. Return to computer capital falls, so those owners suffer a loss of purchasing power regardless of their pattern of consumption

Mobile Labor Immobile Capital: The Case of a Capital- Abundant Country Country (say US) has a comparative disadvantage in ( labor-intensive) rug production and comparative advantage in (capital-intensive) computer production. It opens trade with another country. The price of computers would rise; the price rugs would fall Rug production would fall and computer production would rise »Wages would fall (probably less than proportionally with the price of rugs); the net effect on real wages depends on the combination of rugs and computers workers purchase »The price of computer-specific capital will increase proportionally more than the price of computers; rc/Pc would go up; r C /P R would go up as well »The price of rug-specific capital will fall; the purchasing power of rug-specific capital would fall

In the long run, when capital and labor are both mobile, in the Capital abundant country : The rate of return on capital (in both industries) would increase The purchasing power of rate of return on capital would increase; there would be a magnification effect Wages (in both industries) would decline The purchasing power of workers would decline; there would be a magnification effect

Factor Immobility and Adjustment Costs In any factor endowment models there losers and there winners When there is factor immobility the distribution of the gains from trade tend to be more skewed Generally we expect the gains from trade to exceed is losses The Pareto Criterion

Pareto Criterion If additional goods were distributed such that at least one person would end up with more while others access to the goods would remain unchanged, then you could say that trade increased the welfare or utility of society and the gains from trade met Pareto Criterion. Pareto criterion: Any change that makes at least one person better off without making any other person worse off increases (societal) welfare

Can Free Trade Produce a Pareto- Optimal Outcome? Losers in the short run include the owners of industry-specific factors used in the countrys comparatively-disadvantaged industry Losers in the long run include owners of (scarce) factor used in the countrys comparatively-disadvantaged industry intensively

Adjustment Mechanisms and Adjustment Costs Take from the winners; give to the losers Trade Adjustment Assistance (TAA) The Trade Act of 1974 OTCA of 1988 Helping the losers without retarding the adjustment process The effects of international factor mobility