1. 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

2. 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:
Deal has been in negotiation since Blocked due to auto and beef. (need support of Ford, GM and UAW to pass congress).

3. 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.
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4. 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
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5. © 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?
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6. 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”
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Diminishing Returns
Manufacturing output and labor employment
Holding K fixed
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8. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Diminishing Returns
Diminishing returns to labor – decreasing MPLM and MPLA
Holding K
Constant
Holding T
Constant
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9. 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.
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10. © 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
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11. © 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
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12. © 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
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13. 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
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14. closed-economy equilibrium
Home Country Before Trade
Agriculture Output, QA A U1
Slope = –(PM/PA) B
PPF
Manufacturing Output, QM
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15. 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
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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)
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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
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18. 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
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19. 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
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20. Application: How Large Are Gains from Trade
Dec ~ 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
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21. © 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)
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22. © 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?
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23. 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.
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24. Labor Market Equilibrium
Agriculture
W = PAMPLA LA
Manufacturing
W = PMMPLM LM
Choose “Arrange” and then “Flip Horizontal” for ag.
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25. 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
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26. 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
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27. © 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
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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
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29. 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
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30. © 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
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31. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Real wage for Agr.
LA falls,
So MPLA rises
So w/PA (= MPLA) rises
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32. © 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
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33. Summary: How does trade affect real wages?
PM increases and PA does not change
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34. 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.
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35. 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
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36. How does trade affect Unemployment?
No effect!
Total labor is always LM + LA = so no unemployment
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37. 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,
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38. 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
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39. 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.
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40. 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: )
90% search and relocation expenses up to $1250.
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41. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Summary: Part 2
Labor Market Equilibrium
How does trade affect real wages?
Changes in LA and LM
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42. 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?
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43. 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
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44. Marginal Products of Capital and Land
MPKM rises (falls) if LM rises (falls)
MPTA rises (falls) if LA rises (falls)
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45. 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
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46. 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
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47. © 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
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48. © 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.
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49. Summary: Trade redistributes income
General Equation for the Change in Factor Prices
PM increases and PA does not change
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50. 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.
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51. 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

52. 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.

53. © 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.
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