GAINS AND LOSSES FROM TRADE IN THE SPECIFIC-FACTORS MODEL 3 GAINS AND LOSSES FROM TRADE IN THE SPECIFIC-FACTORS MODEL 1 Specific-Factors Model 2 Earnings of Labor 3 Earnings of Capital and Land 4 Conclusions

International Economics Introduction Opening a country to trade generates winners and losers. Determining who gains and who loses answers many questions about trade politics. Specific-Factors model helps explain who gains and who loses. Short Run Specific-Factor model offers new insights beyond the Ricardian model. International Economics

Specific-Factors Model How does trade affect the earnings of capital, labor, and land? From the Ricardian model, free trade leads to: Rising relative prices in the export sector Falling relative prices in the import sector So what we really want to know is how changes in relative prices affect the earnings of factors Important to distinguish between mobile factors (labour) which can move and immobile factors (land or capital) which are stuck to one sector. International Economics

Specific-Factors Model Will continue to use two countries: Home and Foreign. Home Country Manufacturing uses labor and capital. Agriculture uses labor and land. Diminishing returns to labor—decreasing MPLM and MPLA (see Figure 3.2). International Economics

Specific-Factors Model Diminishing Marginal Product of Labor Figure 3.2 Diminishing Marginal Product of Labor An increase in the amount of labor used lowers the marginal product for both manufacturing and agriculture Figure 3.2 International Economics

Specific-Factors Model Production Possibilities Frontier Figure 3.3 Figure 3.3 Production Possibilities Frontier The production possibilities frontier shows the amount of agricultural and manufacturing outputs that can be produced in the economy. Its slope equals −MPLA/MPLM, the ratio of marginal products of labor in the two industries. The slope of the PPF can be interpreted as the opportunity cost of the manufacturing output—it is the amount of the agricultural good that would need to be given up to obtain one more unit of output in the manufacturing sector. International Economics

Specific-Factors Model Opportunity Cost and Prices As in the Ricardian model, the slope of the PPF equals the opportunity cost or relative price of the good on the horizontal axis: here it is manufacturing. Firms hire labor up to the point where the cost of one more hour of labor (the wage) equals the value of one more hour of labor in production. International Economics

Specific-Factors Model Opportunity Cost and Prices The value of the additional output can be measured by multiplying the price of the good times the additional output, or the MPL. This equality holds for both industries: International Economics

Specific-Factors Model Since we assume that labor is mobile, the wages in the two industries must be equal. Relative price of manufacturing equals the opportunity cost of manufacturing (slope of PPF). International Economics

Specific-Factors Model Home Country without Trade Agriculture Output, QA A U1 Slope = –(PM/PA) B PPF Manufacturing Output, QM International Economics

Specific-Factors Model The Foreign Country Assume the no-trade price in the foreign country (PM*/PA*) is higher than that in the Home Country (PM/PA). For now we will ignore reasons for price differences. Home country has comparative advantage in manufacturing (can produce at lower opportunity cost than Foreign country). International Economics

Specific-Factors Model Overall Gains from Trade When trade opens the world price will end up between the no-trade prices of the Home and Foreign countries. After trade Relative Home price of manufacturing will rise Relative Foreign price of manufacturing will fall Total gains from trade can be measured by the increased utility of the higher indifference curve International Economics

Specific-Factors Model Old production = A New production = B Old consumption = A New consumption = C International Economics

Specific-Factors Model Conclusions The good whose relative price increases becomes the exported good. The good whose relative price decreases is the imported good. A country can never be made worse off from trade. Although a country as a whole is better off from trade, that does not mean that every individual is better off. How are earnings of labor affected in importing and exporting industries after trade? International Economics

International Economics Earnings of Labor Allocation of Labor between Manufacturing and Agriculture Labor Market Equilibrium is where the two curves cross PA*MPLA is drawn from right to left PM*MPLM is drawn from left to right A Labor market equilibrium Wage Manufacturing labor Agriculture labor Total labor supply PAMPLA Value of marginal product of agriculture PM MPLM Value of marginal product of manufacturing W Figure 3.5 Allocation of Labor between Manufacturing and Agriculture The amount of labor used in manufacturing is measured from left to right along the horizontal axis, and the amount of labor used in agriculture is measured from right to left. Labor market equilibrium is at point A, with the wage of W, 0ML units of labor used in manufacturing, and 0AL units of labor used in agriculture. Figure 3.5 International Economics

International Economics Earnings of Labor Figure 3.6 Increase in the Price of Manufactured Goods The vertical distance between the old and new curves is greater than the increase in wages. PM*MPLM shifts up creating a new equilibrium. Wage PMMPLM PAMPLA A W Vertical distance = PM (MPLM) B PM'MPLM W’ ΔW Figure 3.6 Increase in the Price of Manufactured Goods With an increase in the price of the manufactured good, the curve PM • MPLM shifts up to PM’ • MPLM and the equilibrium shifts from point A to point B. The amount of labor used in manufacturing rises from 0ML to 0ML’, and the amount of labor used in agriculture falls from 0AL to 0AL’. The wage increases from W to W’, but this increase is less than the upward shift ∆PM • MPLM. International Economics

International Economics Earnings of Labor Effect on Real Wages Do higher wages translate into higher real wages? Depends on changes in prices. We assumed PA did not change so W/PA has increased—workers can buy more food. We assume that PM increased, as did W; what is the net effect on W/PM? International Economics

International Economics Earnings of Labor Effect on Real Wages We showed in figure 3.6 that ΔW < ΔPM·MPLM If we divide both sides by W we get: ΔW/W is the percentage change in wages International Economics

International Economics Earnings of Labor Effects on Real Wages ΔPM/PM is the percentage change in the price of manufactured goods. Since ΔW/W is a smaller increase, the amount of manufactured goods that can be purchased with the money wage has fallen. The real wage in terms of manufactured goods has decreased. International Economics

International Economics Earnings of Labor Overall Impact on Labor Is labor better off or worse off after the price increase? A person who spends more of his or her income on agricultural goods is better off. But a person who spends more of his or her income on manufactured goods is worse off. In the specific-factors model, the overall effect on the well-being of workers is thus ambiguous. The result is different than what was found in the Ricardian model, where labor unambiguously earned a higher real wage. This warns us that one cannot make unqualified statements about the effects of trade on workers. International Economics

Earnings of Capital and Land Although there are “overall” gains from trade for the country, we have found that labor, the mobile factor, does not necessarily gain What about the earnings of the other factors of production, capital and land, which cannot switch between industries? International Economics

Earnings of Capital and Land Determining the Payment to Capital and Land Capital and Land earn what is left over from sales revenue after labor is paid. Total revenue is price times the quantity sold, and payments to labor are wages times quantity hired. Payments to capital = PM·QM – W·LM Payments to labor = PA·QA – W·LA Taking the payments one step further will be useful. Quantity of land used in agriculture is T acres. Quantity of capital used in manufacturing is K. International Economics

Earnings of Capital and Land Determining the Payment to Capital and Land We can now determine the earnings of capital, RK, and land, RT International Economics

Earnings of Capital and Land Determining the Payment to Capital and Land RK and RT are the rental on capital and land respectively. Rental reflects what these factors earn during a given period when used in these industries. Also, the amount the factors could earn if rented to someone else over the same time. International Economics

Earnings of Capital and Land Determining the Payment to Capital and Land We can also use another method to calculate the rental on capital and land. We can consider the value of the additional output we get from hiring those factors. International Economics

Earnings of Capital and Land Change in the Real Rental on Capital Assume PM increases as before, PA constant. We saw before that wages rise and labor shifts from agriculture to manufacturing. As more labor is used in manufacturing, the marginal product of capital will rise. As more labor leaves agriculture, the marginal product of land will fall. International Economics

Earnings of Capital and Land Change in the Real Rental on Capital General Conclusion: An increase in the quantity of labor used in an industry will raise the marginal product of the factor specific to that industry, and a decrease in labor will lower the marginal product of the specific factor. International Economics

Earnings of Capital and Land We can get more from this conclusion: Remember MPKM = RK/PM PM is rising and we know MPKM is rising. RK must be increasing by more than PM is increasing, in percentage terms. Also remember RK/PA is amount of food that can be purchased by capital owners. RK increased, PA fixed, so RK/PA increases. Real rental on capital is the amount of food that can be increased International Economics

Earnings of Capital and Land Change in the Real Rental on Capital Since capital owners can afford more of both goods, they are better off when PM rises. This is unlike the case of labor, which could buy more of one good but less of the other. The owners of capital are clearly better off under trade than in the no-trade case. International Economics

Earnings of Capital and Land Change in the Real Rental on Land Labor leaves agriculture, causing MPKA to fall. Since MPKA = RT/PA, RT/PA must fall, meaning RT itself must fall (since PA remains constant). This means the real rental on land in terms of food has decreased—landowners cannot buy as much food. And PM has increased, so landowners cannot buy as much of the manufactured good either. Landowners are clearly worse off with trade than in the no-trade case. International Economics

Earnings of Capital and Land Summary Real earnings of capital owners and landowners move in opposite directions. An increase in the relative price of an industry’s output will increase the real rental earned by the factor specific to that industry, but will decrease the real rental of factors specific to other industries. This means that, generally, specific factors in export industries gain, and specific factors in importing industries lose. International Economics

International Economics Numerical Example Manufacturing: Sales Revenue = PMQM = $100 Payments to Labor = WLM = $60 Payments of Capital = RKK = $40 Agriculture Sales Revenue = PAQA = $100 Payments to Labor = QLA = $50 Payments to Land = RTT = $50 International Economics

International Economics Numerical Example Assume PM increases by 10% and PA remains unchanged. Percentage change in labor is 5% ΔPM/PM = 10% ΔPA/PA = 0% ΔW/W = 5% Remember the percent change in wages will be between the percent change in the two industry price changes. International Economics

International Economics Numerical Example Change in the Rental on Capital International Economics

International Economics Numerical Example Change in the Rental on Capital ΔRK/R = (10%*100-5%*60)/40 = 17.5% The percentage increase in rental on capital is greater than percentage increase in the relative price of manufacturing, 10% This holds no matter what, given that the percentage increase in the wage is less than the percentage increase in the price of the manufactured good. International Economics

International Economics Numerical Example Change in Rental on Land Using the same analysis, we can look at how rental rates are affected by an increase in PM We know that wages are increasing which means the rental on land is falling. We can calculate how much. International Economics

International Economics Numerical Example Change in Rental on Land Land rent falls by same percentage as wage increases. This occurs because we assumed labor and land received the same share of sales revenue International Economics

Earnings of Capital and Land General Equation for the Change in Factor Prices All changes in factor and industry prices are related. Assume PM increases and PA does not change, then: International Economics

Earnings of Capital and Land General Equation for the Change in Factor Prices The opposite is true if PM falls. Wages fall by less than percent change in the manufactured good, rental on capital falls by more than the manufacturing price, and rental on land rises. What happens if PA increases? International Economics