GAINS AND LOSSES FROM TRADE IN THE SPECIFIC-FACTORS MODEL

Name: GAINS AND LOSSES FROM TRADE IN THE SPECIFIC-FACTORS MODEL
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Description: GAINS AND LOSSES FROM TRADE IN THE SPECIFIC-FACTORS MODEL

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

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
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. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Why are we concerned with relative prices? The earnings of specific or fixed factors (such as capital and land) go up or down the most with changes in relative prices because they are “stuck” in a sector and cannot be employed elsewhere. Mobile factors (such as labor) can offset losses from changes in relative prices by seeking employment in other sectors. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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). This is a two good, three factor model. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Each country faces a standard Production Possibilities Frontier. Concave to the origin because of diminishing returns to labor in both industries. The slope of the PPF is the negative of the ratio of the marginal products (see figure 3.3). The slope is the opportunity cost of producing one unit of manufacturing. If L continues to move to manufacturing, MPLA rises and MPLM falls so the slope of the PPF gets steeper. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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). PM*MPLM = PA*MPLA  PM/PA = MPLA/MPLM The no-trade equilibrium for Home is shown on the next slide at point A PM/PA = −(slope of PPF) = −(slope of indifference curve) The indifference curve is tangent to PPF © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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). © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Home Country with Trade Agriculture Output, QA Once trade is opened and consumers 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 A Gains from trade Figure 3.4 Increase in the Relative Price of Manufactures In the absence of international trade, the economy produces and consumes at point A. The relative price of manufactures, PM/PA, is the slope of the line tangent to the PPF and indifference curve U1, at point A. With international trade, the economy is able to produce at point B and consume at point C. The world relative price of manufactures, (PM/PA)W, is the slope of the line BC. The rise in utility from U1 to U2 is a measure of the gains from trade for the economy. U1 Slope = –(PM/PA) B PPF Manufacturing Output, QM © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

What has happened at Home? The relatively higher price 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 — moving individuals to a higher indifference curve allowing them to now consume at C (instead of A). Good whose price rises (falls) becomes the exported (imported) good. © 2008 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 affected in importing and exporting industries after trade? Determination of Wages We can show the amount of labor used in each industry on one graph. Labor used in manufacturing is measured from the left axis. Labor used in agriculture is measured from the right axis. See Figure 3.5 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Earnings of Labor Change in Relative Price of Manufactures Assume the relative price of manufactures rises (because of the foreign demand for them). A rise in relative price of manufacturing can be caused by an increase in PM or a decrease in PA. Effect on real wage is the same. Assume PM rises PM*MPLM curve shifts up by Δ PM ∙ MPLM New equilibrium at higher wage LM has increased and LA has decreased © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Earnings of Labor Effect on Real Wages Do higher wages translate into higher real wages? 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? We showed in figure 3.6 that ΔW < ΔPM·MPLM If we divide both sides by W we get: © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Earnings of Labor Effects on Real Wages is the percentage change in the price of manufactured goods. Since ΔW/W < ΔPM/PM, 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. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Earnings of Labor Is labor better 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. The overall effect on the well-being of workers is thus ambiguous. Although ambiguous, this conclusion is important. 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. The effect of trade on real wages can be complex. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Earnings of Labor Unemployment in Specific Factors Model Total labor is always LM + LA so no unemployment. Why do we ignore unemployment? Unemployment is usually considered a macro phenomenon affected by business cycles. Many people laid off due to trade often find new jobs within a reasonable amount of time, often with higher wages. Even if we were to consider the spells of unemployment due to trade, we see that workers can find new jobs typically in the expanding exporting industry. Even after we take into account that workers eventually find new jobs, we still cannot conclude whether trade is necessarily good or bad for workers © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Manufacturing and Services in the US
Manufacturing Services in the U.S.: Employment and Wages Across Sectors. Figure 3.7 shows employment in U.S. manufacturing industry over time. Figure 3.8 shows real wages earned by production workers in manufacturing, all private services, and in information services. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Figure 3.7 U.S. Manufacturing Sector Employment, 1973–2003 Employment in the U.S. manufacturing sector is shown on the left axis, and the share of manufacturing employment in total U.S. employment is shown on the right axis. Both manufacturing employment and its share in total employment have been falling over time, indicating that the service sector has been growing. Source: Council of Economic Advisers, 2004, Table B 46. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Figure 3.8 Real Hourly Earnings of Production Workers This chart shows the real wages (in constant 2003 dollars) earned by production workers in U.S. manufacturing, in all private services, and in information services (a subset of all private services). While wages are slightly higher in manufacturing than all private services, the information service industry pays wages that are substantially higher than those in manufacturing. Real wages for production workers fell in most years between 1979 and 1995 but have been rising since then. Source: Historical Data for the “B” Tables of the Employment Situation Release. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Conclusions Wages differ across different sectors in the economy, so the assumption that wages are the same in both industries is a simplification. Many workers that are displaced every year for various reasons must find jobs elsewhere. Some are laid off because of import competition, but there are many other reasons The majority of workers find new jobs within 2–3 years, but not necessarily at the same wage Real wages for all production workers fell in most years between 1972–95, but have since risen. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Job Losses in Manufacturing and Service Industries, 2003–2005 Table 3.1 Job Losses in Manufacturing and Service Industries, 2003–2005 This table shows the number of displaced (or laid-off) workers in manufacturing and service industries from 2003 to Between 65% and 70% of these workers were re-employed by January 2006, with about one-half earning less in their new jobs and one-half earning the same or more. Source: U.S. Bureau of Labor Statistics, Source: U.S. Bureau of Labor Statistics, © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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? Determining the Payment to Capital and Land Capital and Land earn what is left over from sales revenue after labor is paid. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Determining the Payment to Capital and Land Payments to capital = PM·QM – W·LM Payments to land = PA·QA – W·LA Let T denote land and K denote capital. We can now determine the earnings of capital, RK, and land, RT © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Determining the Payment to Capital and Land RK and RT reflect 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. Alternatively, we can calculate the rental on capital and land via the value of the additional output we get from hiring those factors. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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. 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. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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 Also remember RK/PA is amount of food that can be purchased by capital owners. RK increased, PA fixed, so RK/PA increases. The owners of capital are clearly better off under trade than in the no-trade case. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Change in the Real Rental Rate on Land Labor leaves agriculture, causing MPKA to fall. Since MPKA = RT/PA, RT/PA must fall, meaning RT falls PA has not changed and PM has increased, so landowners cannot buy as much of either good. Landowners are clearly worse off with trade. Summary 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. Generally, specific factors in export industries gain, and specific factors in importing industries lose. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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 Assume PM increases by 10% and PA remains unchanged. Percentage change in labors wages 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. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Numerical Example Change in the Rental Rate on Capital ΔRK/R = (10%*100-5%*60)/40 = 17.5% The percentage increase in rental on capital is greater than the 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. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Numerical Example Change in Rental Rate on Land We know that wages are increasing which means the rental on land is falling. We can calculate how much. Land rent falls by same percentage as wage increases. This occurs because we assumed labor and land received the same share of sales revenue dRT/RT = -5%*(50/50) = -5% © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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: We get what is called factor price magnification. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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? © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

What It All Means The earnings of specific factors change the most from relative price changes due to international trade. This is because these factors (land and capital) cannot move between industries. The earnings changes are in opposite directions and so the interests of T and K are opposed to each other. Changes in wages paid to labor are less extreme. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

GAINS AND LOSSES FROM TRADE IN THE SPECIFIC-FACTORS MODEL

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