Chapter 3 Specific Factors and Income Distribution

2  The Specific Factors Model  International Trade in the Specific Factors Model  Income Distribution and the Gains from Trade  The Political Economy of Trade: A Preliminary View Kernel of the Chapter

3  Assumptions of the Model One economy that can produce two goods, manufactures and food. three factors of production; labor (L), capital (K) and land (T for terrain). 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 –Land and capital are both specific factors. Perfect Competition prevails in all markets. The Specific Factors Model

4 The production function for good X gives the maximum quantities of good X that a firm can produce with various amounts of factor inputs. –For instance, the production function for manufactures (food) tells us the quantity of manufactures (food) that can be produced given any input of labor and capital (land). The Specific Factors Model

5 The production function for manufactures is given by Q M = Q M (K, L M ) (3-1) The production function for food is given by Q F = Q F (T, L F ) (3-2) The Specific Factors Model The full employment of labor condition LM + LF = L (3-3)

6  Production Possibilities To analyze the economy’s production possibilities, we need only to ask how the economy’s mix of output changes as labor is shifted from one sector to the other. Figure 3-1 illustrates the production function for manufactures. The Specific Factors Model

7 Q M = Q M (K, L M ) Figure 3-1: The Production Function for Manufactures The Specific Factors Model Labor input, L M Output, Q M

8 The shape of the production function reflects the law of diminishing marginal returns. Figure 3-2 shows the marginal product of labor, which is the increase in output that corresponds to an extra unit of labor. The Specific Factors Model

9 MPL M Figure 3-2: The Marginal Product of Labor The Specific Factors Model Labor input, L M Marginal product of labor, MPL M

10 Q F =Q F (K, L F ) Q M =Q M (K, L M ) L2ML2M L2FL2F L L AA 1'1' 3'3' PP Economy’s production possibility frontier (PP) Production function for manufactures Economy’s allocation of labor (AA) Production function for food Q2FQ2F Q2MQ2M 2'2' Labor input in food, L F (increasing  ) Output of manufactures, Q M (increasing  ) Labor input in manufactures, L M (increasing  ) Output of food, Q F (increasing  ) Figure 3-3: The Production Possibility Frontier in the Specific Factors Model The Specific Factors Model

11  Prices, Wages, and Labor Allocation How much labor will be employed in each sector? Demand for labor: The Specific Factors Model

12 The demand curve for labor in the manufacturing sector can be written: MPL M x P M = w (3-4) The demand curve for labor in the food sector can be written: MPL F x P F = w (3-5) The Specific Factors Model

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

14 P M X MPL M (Demand curve for labor in manufacturing) P F X MPL F (Demand curve for labor in food) Wage rate, W W1W1 1 L1ML1M L1FL1F Total labor supply, L Labor used in manufactures, L M Labor used in food, L F Figure 3-4: The Allocation of Labor The Specific Factors Model

15  At the production point -MPL F /MPL M = -P M /P F (3-7) The Specific Factors Model Slope = -(P M /P F ) 1 1 Q1FQ1F Q1MQ1M Output of manufactures, Q M Output of food, Q F PP Figure 3-5: Production in the Specific Factors Model

16 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 The Specific Factors Model

17 W1W1 1 P F increases 10% Wage rate, W P F 1 X MPL F Labor used in manufactures, L M Labor used in food, L F 10% wage increase P M increases 10% P M 1 X MPL M W2W2 2 P F 2 X MPL F P M 2 X MPL M Figure 3-6: An Equal Proportional Increase in the Prices of Manufactures and Food The Specific Factors Model

18 When both prices change in the same proportion, no real changes occur. –The real incomes of capital owners and landowners also remain the same. The Specific Factors Model

19 When only P M rises, the wage rate (w) does not rise as much as P M since manufacturing employment increases and thus the marginal product of labor in that sector falls. The Specific Factors Model

20 P F 1 X MPL F Wage rate, W P M 1 X MPL M 2 W 2 Labor used in food, L F Labor used in manufactures, L M Amount of labor shifted from food to manufactures Wage rate rises by less than 7% 7% upward shift in labor demand P M 2 X MPL M 1 W 1W 1 Figure 3-7: A Rise in the Price of Manufactures The Specific Factors Model

21 PP Slope = - (P M /P F ) 1 Output of manufactures, Q M Output of food, Q F Slope = - (P M /P F ) 2 1 Q1FQ1F Q1MQ1M 2 Q2FQ2F Q2MQ2M Figure 3-8: The Response of Output to a Change in the Relative Price of Manufactures The Specific Factors Model

22 Relative quantity of manufactures, Q M /Q F Relative price of manufactures, P M /P F RD RS Figure 3-9: Determination of Relative Prices 1 (P M /P F ) 1 (Q M /Q F ) 1 The Specific Factors Model

23  Relative Prices and the Distribution of Income Suppose that P M increases by 10%. Then, we would expect the wage to rise by less than 10%, say by 5%. What is the economic effect of this price increase on the incomes of the following three groups? –Workers –Owners of capital –Owners of land The Specific Factors Model

24 Workers: –We cannot say whether workers are better or worse off;. Owners of capital: – They are definitely better off. Landowners: – They are definitely worse off. The Specific Factors Model

25  Assumptions of the model Assume that both countries (Japan and America) with the same relative demand. The only source of international trade is the differences in relative supply which arises from the difference in: –Technology –Factors of production (capital, land, labor) International Trade in the Specific Factors Model

26  Resources and Relative Supply What are the effects of an increase in the supply of capital stock on the outputs of manufactures and food? International Trade in the Specific Factors Model

27 P M X MPL M 2 P F 1 X MPL F Wage rate, W P M X MPL M 1 W 1W W 2W 2 Increase in capital stock, K Amount of labor shifted from food to manufactures Labor used in manufactures, L M Labor used in food, L F International Trade in the Specific Factors Model Figure 3-10: Changing the Capital Stock

28 An increase in the supply of capital would shift the relative supply curve to the right. An increase in the supply of land would shift the relative supply curve to the left. The effect of an increase in the labor force? –The effect on relative output is ambiguous, although both outputs increase. International Trade in the Specific Factors Model

29  Trade and Relative Prices Suppose that Japan has more capital per worker than America, while America has more land per worker than Japan. International trade leads to a convergence of relative prices. International Trade in the Specific Factors Model

30 Relative quantity of manufactures, Q M /Q F Relative price of manufactures, P M /P F (P M /P F ) W (P M /P F ) A (P M /P F ) J International Trade in the Specific Factors Model Figure 3-11: Trade and Relative Prices RD WORLD RS A RS WORLD RS J

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

32 Budget constraint (slope = -P M /P F ) Consumption of manufactures, D M Output of manufactures, Q M Consumption of food, D F Output of food, Q F Production possibility curve International Trade in the Specific Factors Model Figure 3-12: The Budget Constraint for a Trading Economy Q1MQ1M 1 Q1FQ1F

33 QJFQJF QAFQAF DAFDAF DJFDJF QAMQAM DAMDAM QJMQJM DJMDJM Japan’s food imports America’s food exports Japan’s manufactures exports America’s manufactures imports Quantity of manufactures Quantity of food Japanese budget constraint American budget constraint International Trade in the Specific Factors Model Figure 3-13: Trading Equilibrium

34 Income Distribution and the Gains from Trade  To assess the effects of trade on particular groups, the key point is that international trade shifts the relative price of manufactures and food.  Trade benefits the factor that is specific to the export sector of each country, but hurts the factor that is specific to the import-competing sectors.  Trade has ambiguous effects on mobile factors.

35  Could those who gain from trade compensate those who lose, and still be better off themselves?  The fundamental reason why trade potentially benefits a country is that it expands the economy’s choices. This expansion makes it possible to redistribute income in such a way that everyone gains from trade. Income Distribution and the Gains from Trade

36 Budget constraint (slope = - P M /P F ) PP Consumption of manufactures, D M Output of manufactures, Q M Consumption of food, D F Output of food, Q F Q1MQ1M Q1FQ1F 1 2 Figure 3-14: Trade Expands the Economy’s Consumption Possibilities Income Distribution and the Gains from Trade

37  Trade often produces losers as well as winners.  Optimal Trade Policy The government must somehow weigh one person’s gain against another person’s loss. Any realistic understanding of how trade policy is determined must look at the actual motivations of policy. The Political Economy of Trade: A Preliminary View

38  Income Distribution and Trade Politics Those who gain from trade are a much less concentrated, informed, and organized group than those who lose. –Example: Consumers and producers in the U.S. sugar industry The Political Economy of Trade: A Preliminary View