3 1 Specific-Factors Model 2 Earnings of Labor 3 Earnings of Capital and Land 4 Conclusions Gains and Losses from Trade in the Specific-Factors Model Readings: Chapter 3

U.S.-South Korea Free Trade Agreements Announced in December 3, 2010. Tariff cuts are not uniform across sectors $1 billion of U.S. farm exports will become duty-free immediately But U.S. beef exports still faces a 40% tariff (to be phased out in 15 years) The U.S. tariff on auto imports (2.5%) will remain until the 5th year. Source: http://money.cnn.com/2010/12/03/news/international/south_korea_free_trade/index.htm. Deal has been in negotiation since 2007. Blocked due to auto and beef. (need support of Ford, GM and UAW to pass congress).

Bolivian Politics and Trade Evo Morales. Current president, 2005 campaign. First Aymara Indian president. Tremendously popular: 2009, constitution was changed so that he could serve another term. Why so popular? One thing: allowing indigenous people to take control of oil and gas resources in Bolivia. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Specific-Factors Model Gains from trade are not evenly distributed across industries The specific-factor model helps explain who gain and who lose from trade © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Road Map Part 1 How does trade affect the Home country? Before trade With trade Part 2 How does trade affect real wages? Part 3 How does trade affect the returns to capital and land? © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Specific-Factors Model Home Country Manufacturing uses labor (LM) and capital (K) Agriculture uses labor (LA) and land (T) Labor moves freely between manufacturing and agriculture Capital is “stuck” in manufacturing (i.e. it has NO USE in agriculture) Land is “stuck” in agriculture (i.e. it has NO USE in manufacturing) Labor is the “mobile factor” Capital and land are “specific factors” © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Diminishing Returns Manufacturing output and labor employment Holding K fixed © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Diminishing Returns Diminishing returns to labor – decreasing MPLM and MPLA Holding K Constant Holding T Constant © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Notes: Diminishing Returns As more labor is used, the manufacturing output goes up, but at a diminishing rate, holding K constant. As more labor is used, the marginal product of labor in manufacturing, MPLM, decreases, holding K constant. The statements for agriculture are analogous. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor PPF and Slope PPF is concave shaped From A to B: Loss in QA = -MPLA Gain in QM = MPLM © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Notes: PPF and Slope Each country faces a standard Production Possibilities Frontier Concave to the origin due to diminishing returns to labor in both industries The slope of the PPF is the ratio of the marginal products Ratio is the opportunity cost of producing one unit of manufacturing © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Wage Equation Wages Firms hire labor up to the point where the marginal benefits equal the marginal costs This relationship holds for both industries © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Relative Price Before Trade 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) Thus as in the Ricardian model, |slope of the PPF| = the relative price of manufacturing = the Opportunity Cost of manufactured good © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

closed-economy equilibrium Home Country Before Trade Agriculture Output, QA A U1 Slope = –(PM/PA) B PPF Manufacturing Output, QM © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Notes: closed-economy equilibrium Equilibrium for Home country is A. In equilibrium PM/PA = |slope of PPF| Consumer’s indifference curve is tangent to PPF This is the same as in the Ricardian model © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Foreign Country Assume that the Foreign Country has the comparative advantage in the agricultural good; i.e. (PM*/PA*) > (PM/PA) Then at equilibrium with free trade, the equilibrium price (PM/PA)W falls between (PM*/PA*) and (PM/PA) © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Gains from trade Figure 3.4 b – Home Country w/Trade U1 Manufacturing Output, QM A B Agriculture Output, QA PPF Slope = –(PM/PA) Once trade is opened and consumer face the new world price, they are able to move to a higher indifference curve (U2). Trade makes prices for manufacturing in Home rise as seen from new price line The gains from trade can be measured by the rise in utility from U1 to U2. C U2 Slope = –(PM/PA)W Gains from trade © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Equilibrium with Trade Old production – A New production – B Old consumption – A New consumption - C U1 Manufacturing Output, QM A B Agriculture Output, QA PPF Slope = –(PM/PA) C U2 Slope = –(PM/PA)W Gains from trade © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Notes: Equilibrium with trade What has happened at Home? Relatively higher prices in manufacturing attracts more workers to that industry - production now at point B (instead of A) Manufactured goods are exported and Agricultural goods are imported Consumption changes move individuals to a higher indifference curve, allowing them to now consume at C (instead of A) Home does not completely specialize in manufacturing and still produces agriculture © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Application: How Large Are Gains from Trade Dec. 1807 ~ Mar. 1809, the U.S. imposed an embargo (a complete halt of international trade) Exports (cotton, tobacco, rice, etc.) dropped from $49 M to $9 M Cost of embargo estimated at 5% of U.S. GDP then In the great depression, loss in output was 9% of U.S. GDP © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Summary of Part 1 Diminishing Returns PPF is concave-shaped Home produces manufacturing AND agriculture with free trade (no specialization) OC changes with output and labor employment Many results derived for Ricardian model still work Wage = price x marginal product of labor OC = relative price before trade (comparative advantage) © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Earnings of Labor 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 (i.e. real wages) affected by trade? © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Labor Market Equilibrium Determination of Wages We can show the uses of labor in each industry on one graph Uses of labor and wages are directly dependent on the marginal product of labor Firms hire up to the point where wages equal the value of the marginal product. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Labor Market Equilibrium Agriculture W = PAMPLA LA Manufacturing W = PMMPLM LM Choose “Arrange” and then “Flip Horizontal” for ag. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Labor Market Equilibrium Labor Market Equilibrium is where the two curves cross PM*MPLM is drawn from left to right PA*MPLA is drawn from right to left PM PA K, L_bar and T Are given © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Notes: Labor Market Equilibrium As long as the labor market is in equilibrium, there is no reason for labor to move between sectors However, equilibrium can change as other factors in the markets changes Labor will move to the industry where it is paid (valued) more © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Effects of trade Change in Relative Price of Manufactures From no-trade equilibrium to trade equilibrium, relative price of manufacturing good increases. (PM/PA)W > (PM/PA) This can be caused by an increase in PM or a decrease in PA; effect on real wage is the same Assume PM rises and PA does not change © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Effects of Trade PM*MPLM shifts up creating a new equilibrium The vertical distance between the old and new curves is greater than the increase in wages © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Summary: effects of trade Effect on Wage PM*MPLM curve shifts up by Δ PM*MPLM New equilibrium at higher wage LM has increased and LA has decreased © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Real wages Home makes both mfg. and agr. With trade W = PMW x MPLM = PAW x MPLA Real wages equal marginal products of labor © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Real wage for Agr. LA falls, So MPLA rises So w/PA (= MPLA) rises © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Real wage for Mfg. LM rises, So MPLM falls So w/PM (= MPLA) falls i.e. wages “rises by less” than PM © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Summary: How does trade affect real wages? PM increases and PA does not change © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Notes: How does trade affect real wages? Ambiguous We have cannot make unqualified statements about the effect of trade on workers. The effect of trade on real wages is complex Is labor better off or worse off after the price increase? A person who spends much of their income on agricultural goods is probably better off and vice versa. In the specific-factors model, the overall effect on the well-being of workers has an ambiguous effect. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Summary: Steps We’ve Taken Want to see trade => real wages w But wages depend on marginal products of labor (e.g. W/PM = MPLM ) Marginal products of labor, in turn, depend on labor employments (e.g. MPLM depends on LM) So we go trade => LM and LA => MPLM and MPLA => real wages © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

How does trade affect Unemployment? No effect! Total labor is always LM + LA = so no unemployment © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Employment Churning in the U.S. Economy These are people who have been employed for all 3 years. Another 4.3 million are displaced who are employed for < 3 years. Source: U.S. Bureau of Labor Statistics, http://www.bls.gov/news.release/disp.nr0.htm © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Notes: How does trade affect Unemployment? Why do we ignore unemployment? Unemployment usually considered a macro phenomenon affected by business cycles Many people laid off due to trade often find new jobs in a reasonable amount of time, sometimes with higher wages © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Trade Adjustment Assistance (TAA) Program Unemployment Insurance (UI) Involuntary unemployment State UI agencies. Up to 26 weeks and $390 per week in Indiana, 2008. The UI benefits range from $50 to $390 per week, depend on earnings in base period. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Trade Adjustment Assistance (TAA) Program After normal UI is exhausted; employment related to foreign competition; U.S. DOL Training: up to 104 weeks income support: 26 after UI, plus 52 if training job search and relocation expenses TAA is a small program In 2011, total expense $300 million, 27,000 workers (source: http://en.wikipedia.org/wiki/Trade_Adjustment_Assistance#Program_Cost ) 90% search and relocation expenses up to $1250. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Summary: Part 2 Labor Market Equilibrium How does trade affect real wages? Changes in LA and LM © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Earnings of Capital and Land Although there are “overall” gains from trade for the country, we know that the effect of trade on labor earnings is ambiguous. What happen to owners of capital and land? © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Earnings of Capital and Land Determining the Payment to Capital and Land We consider the value of the additional output we get from hiring those factors, similar to the way we derive the wage equations: MPKM is the marginal product of capital in manufacturing MPTA is the marginal product of land in agriculture © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Marginal Products of Capital and Land MPKM rises (falls) if LM rises (falls) MPTA rises (falls) if LA rises (falls) © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Notes: 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 © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Real Returns to Capital Capital is used in Mfg. only: RK = PM × MPKM RK rises because (1) PM rises (2) MPKM rises (because LM rises) Real return in terms of Agr.: RK/PA Rises because RK rises and PA doesn’t change Real return in terms of Mfg.: RK/PM = MPKM Rises because MPKM rises (because LM rises) Intuitively, RK “rises by more” than PM Rigorously, Capital owners are better-off © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Real Returns to Land Land is used in Agr. only: RT = PA × MPTA RT falls because (1) PA doesn’t change (2) MPTA falls (because LA falls) Real return in terms of Mfg.: RT/PM falls because RT falls and PM rises Real return in terms of Agr.: RT/PA = MPTA falls because MPTA falls (because LA falls) This means that Land owners are worse-off © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Intuition Why do capital owners benefit from trade? (1) capital is specific to mfg. (2) interests of capital owners are tied to mfg. (3) mfg. expands with free trade Why do land owners lose from trade? (1) land is specific to agr. (2) interests of land owners are tied to agr. (3) agr. contracts with free trade Assumptions: K and T do not change. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Summary: Trade redistributes income General Equation for the Change in Factor Prices PM increases and PA does not change © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Application: Prices in Coffee Price of coffee fluctuates wildly from year to year As world prices fluctuate, the farmers that grow them see their incomes fluctuate. Why? Specific factors model: specific factors. More fluctuation, etc. etc. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Application: Fair Trade Coffee In 1999, TransFair USA started offering fixed prices to coffee farmers in Central America, bypassing middle men This fair-trade coffee gained momentum following the collapse of coffee price in 2001

Application: Fair Trade Coffee In 2005, however, coffee prices recovered in the world market The fixed price offered through fair trade arrangements was lower than the prices offered by middlemen Coffee growers were torn between being loyal to the fair-trade contract, and delivering to middlemen for higher earnings.

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Summary Part 3 Rentals of capital and land Capital owners gain from trade because trade expands mfg. (K does not change) Land owners lose from trade because trade contracts agr. (T does not change) Comparison of percentage changes in PA, PM, w, RT and RK. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor