Chapter 4

Specific Factors and Income

Distribution
Chapter Organization

• Introduction
• The Specific Factors Model
• International Trade in the Specific Factors
Model
• Income Distribution and the Gains from Trade
• Political Economy of Trade: A Preliminary View
• International Labor Mobility
• Summary
Introduction
• If trade is so good for the economy, why is there
such opposition?
• Two main reasons why international trade has
strong effects on the distribution of income within
a country:
- Resources cannot move immediately or costlessly
from one industry to another.
- Industries differ in the factors of production they
demand.
The Specific Factors Model

• The specific factors model allows trade to

affect income distribution.
• Assumptions of the model:
- Two goods, cloth and food.
- Three factors of production: labor (L), capital
(K) and land (T for terrain).
- Perfect competition prevails in all markets.
The Specific Factors Model
(cont.)

- Cloth produced using capital and labor (but not land).

- Food produced using land and labor (but not capital).
- Labor is a mobile factor that can move between
sectors.
- Land and capital are both specific factors used only in
the production of one good.
The Specific Factors Model
(cont.)
• How much of each good does the economy produce?
• The production function for cloth gives the quantity of
cloth that can be produced given any input of capital
and labor:

QC = QC (K, LC) (4-1)

- QC is the output of cloth

- K is the capital stock
- LC is the labor force employed in cloth
The Specific Factors Model
(cont.)
• The production function for food gives the quantity
of food that can be produced given any input of land
and labor:
QF = QF (T, LF) (4-
2)

- QF is the output of food

- T is the supply of land

- LF is the labor force employed in food

Production Possibilities

• How does the economy’s mix of output change as

labor is shifted from one sector to the other?
• When labor moves from food to cloth, food
production falls while output of cloth rises.
• Figure 4-1 illustrates the production function for
cloth.
Fig. 4-1: The Production Function for
Cloth
Production Possibilities (cont.)
• The shape of the production function reflects the law
of diminishing marginal returns.
– Adding one worker to the production process
(without increasing the amount of capital) means
that each worker has less capital to work with.
– Therefore, each additional unit of labor adds less
output than the last.
• Figure 4-2 shows the marginal product of labor,
which is the increase in output that corresponds to an
extra unit of labor.
Fig. 4-2: The Marginal Product of
Labor
Production Possibilities (cont.)

• For the economy as a whole, the total labor

employed in cloth and food must equal the total
labor supply:

LC + LF = L (4-3)

• Use these equations to derive the production

possibilities frontier of the economy.
Production Possibilities (cont.)
• Use a four-quadrant diagram to construct production
possibilities frontier in Figure 4-3.

- Lower left quadrant indicates the allocation of labor.

- Lower right quadrant shows the production function for cloth
from Figure 4-1.
- Upper left quadrant shows the corresponding production
function for food.
- Upper right quadrant indicates the combinations of cloth and
food that can be produced.
Fig. 4-3: The Production Possibility Frontier in
the Specific Factors Model
Production Possibilities (cont.)

• Why is the production possibilities frontier curved?

- Diminishing returns to labor in each sector
cause the opportunity cost to rise when an
economy produces more of a good.
- Opportunity cost of cloth in terms of food is the
slope of the production possibilities frontier –
the slope becomes steeper as an economy
produces more cloth.
 Production Possibilities (cont.)
• Opportunity cost of producing one more yard of cloth is MPLF/MPLC
pounds of food.
- To produce one more yard of cloth, you need 1/MPLC hours of labor.
- To free up one hour of labor, you must reduce output of food by
MPLF pounds.

- To produce less food and more cloth, employ less in food and more
in cloth.
- The marginal product of labor in food rises and the marginal
product of labor in cloth falls, so MPLF/MPLC rises.
Prices, Wages, and Labor
Allocation
• How much labor is employed in each sector?
- Need to look at supply and demand in the labor
market.
• Demand for labor:
- In each sector, employers will maximize profits by
demanding labor up to the point where the value
produced by an additional hour equals the
marginal cost of employing a worker for that hour.
Prices, Wages, and Labor
Allocation (cont.)
• The demand curve for labor in the cloth sector:

MPLC x PC = w (4-4)
- The wage equals the value of the marginal
product of labor in manufacturing.

• The demand curve for labor in the food sector:

MPLF x PF = w (4-5)
- The wage equals the value of the marginal
product of labor in food.
Prices, Wages, and Labor
Allocation (cont.)

• Figure 4-4 represents labor demand in the two sectors.

• The demand for labor in the cloth sector is MPLC from

Figure 4-2 multiplied by PC.
• The demand for labor in the food sector is measured
from the right.
• The horizontal axis represents the total labor supply L.
Prices, Wages, and Labor Allocation
(cont.)
• The two sectors must pay the same wage because labor can
move between sectors.
• If the wage were higher in the cloth sector, workers would
move from making food to making cloth until the wages
become equal.
- Or if the wage were higher in the food sector, workers
would move in the other direction.
• Where the labor demand curves intersect gives the equilibrium
wage and allocation of labor between the two sectors.
Fig. 4-4: The Allocation of Labor
Prices, Wages, and Labor
Allocation (cont.)

• At the production point, the production possibility

frontier must be tangent to a line whose slope is
minus the price of cloth divided by that of food.
• Relationship between relative prices and output:

- MPLF/MPLC = -PC/PF (4-6)

Fig. 4-5: Production in the Specific
Factors Model
Prices, Wages, and Labor
Allocation (cont.)

• What happens to the allocation of labor and

the distribution of income when the prices of
food and cloth change?
• Two cases:

1. An equal proportional change in prices

2. A change in relative prices
Prices, Wages, and Labor
Allocation (cont.)
• When both prices change in the same proportion,
no real changes occur.
- The wage rate (w) rises in the same
proportion as the prices, so real wages (i.e.,
the ratios of the wage rate to the prices of
goods) are unaffected.
- The real incomes of capital owners and
landowners also remain the same.
Fig. 4-6: An Equal-Proportional Increase in
the Prices of Cloth and Food
Prices, Wages, and Labor
Allocation (cont.)

• When only PC rises, labor shifts from the food

sector to the cloth sector and the output of
cloth rises while that of food falls.
• The wage rate (w) does not rise as much as PC
since cloth employment increases and thus the
marginal product of labor in that sector falls.
Fig. 4-7: A Rise in the Price of
Cloth
Fig. 4-8: Response of Output to a
Change in the Relative Price of
Cloth
Fig. 4-9: Determination of Relative
Prices
Prices, Wages, and Labor
Allocation (cont.)

• Relative Prices and the Distribution of Income

- Suppose that PC increases by 10%. Then, the
wage would rise by less than 10%.

• What is the economic effect of this price increase

on the incomes of the following three groups?
- Workers, owners of capital, and owners of land
Prices, Wages, and Labor
Allocation (cont.)

• Owners of capital are definitely better off.

• Landowners are definitely worse off.
• Workers: cannot say whether workers are
better or worse off:
- Depends on the relative importance of
cloth and food in workers’ consumption.
 International Trade in the
Specific Factors Model
• Trade and Relative Prices
- The relative price of cloth prior to trade is determined by the
intersection of the economy’s relative supply of cloth and its
relative demand.
- Free trade relative price of cloth is determined by the
intersection of world relative supply of cloth and world relative
demand.
- Opening up to trade increases the relative price of cloth in an
economy whose relative supply of cloth is larger than for the
world as a whole.
Fig. 4-10: Trade and Relative
Prices
International Trade in the Specific
Factors Model (cont.)
• Gains from Trade
- Without trade, the economy’s output of a good
must equal its consumption.
- International trade allows the mix of cloth and
food consumed to differ from the mix produced.
- The country cannot spend more than it earns:

PC x DC + PF x DF = PC x QC +PF x QF
International Trade in the Specific
Factors Model (cont.)
• The economy as a whole gains from trade.
- It imports an amount of food equal to the relative
price of cloth times the amount of cloth exported:
DF - QF = (PC / PF) x (QC – DC )
- It is able to afford amounts of cloth and food that
the country is not able to produce itself.
- The budget constraint with trade lies above the
production possibilities frontier in Figure 4-11.
Fig. 4-11: The Budget Constraint for a Trading
Economy and Gains from Trade
Income Distribution and the
Gains from Trade
• International trade shifts the relative price of
cloth to food, so factor prices change.
• 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.
Income Distribution and the
Gains from Trade (cont.)
• Trade benefits a country by expanding choices.
- Possible to redistribute income so that everyone
gains from trade.
- Those who gain from trade could compensate
those who lose and still be better off
themselves.
- That everyone could gain from trade does not
mean that they actually do – redistribution
usually hard to implement.
The Political Economy of Trade: A
Preliminary View

• Trade often produces losers as well as winners.

• Optimal trade policy must weigh one group’s
gain against another’s loss.
- Some groups may need special treatment
because they are already relatively poor (e.g.
shoe and garment workers in the United
States).
• Most economists strongly favor free trade.
 The Political Economy of Trade: A
Preliminary View (cont.)
• Income Distribution and Trade Politics
- Typically, 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, respectively
- Governments usually provide a “safety net” of income
support to cushion the losses to groups hurt by trade (or
other changes).
Trade and Unemployment
(cont.)
• Trade shifts jobs from import-competing to export
sector.
- Process not instantaneous – some workers will be
unemployed as they look for new jobs.
• How much unemployment can be traced back to
trade?
- From 1996 to 2008, only about 2.5% of involuntary
displacements stemmed from import competition or
plants moved overseas.
Trade and Unemployment
(cont.)
• Figure 4-12 shows that there is no obvious correlation
between unemployment rate and imports relative to
GDP for the U.S.
- Unemployment is primarily a macroeconomic
problem that rises during recessions.
- The best way to reduce unemployment is by
adopting macroeconomic policies to help the
economy recover, not by adopting trade
protection.
Fig. 4-12: Unemployment and Import Penetration i
the U.S.

Source: US Bureau of Economic Analysis for imports and US Bureau of Labor Studies for unemployment.
Movements in Factors of
Production
• Movements in factors of production include
- labor migration
- the transfer of financial assets through
international borrowing and lending
- transactions of multinational corporations
involving direct ownership of foreign firms
• Like movements of goods and services (trade),
movements of factors of production are politically
sensitive and are often restricted.
International Labor Mobility
• Why does labor migrate and what effects does
labor migration cause?
• Workers migrate to wherever wages are highest.
• Consider movement of labor across countries
instead of across sectors.
• Suppose two countries produce one non-traded
good (food) using two factors of production:
- Land cannot move across countries but labor
can.
International Labor Mobility
(cont.)
• Figure 4-13 finds the equilibrium wage and labor
allocation with migration across countries.
- Similar to how Figure 4-4 determined the equilibrium
allocation of labor between sectors.

• Start with OL1 workers in Home earning a lower real

wage (point C) than the L1O* workers in Foreign
(point B).
- Lower wage due to less land per worker (lower
productivity).

• Workers in the home country want to migrate to the

foreign country where they can earn more.
 International Labor Mobility
(cont.)
• If no obstacles to labor migration exist, workers move from Home
to Foreign until the purchasing power of wages is equal across
countries (point A), with OL2 workers in Home and L2O* workers in
Foreign.
- Emigration from Home decreases the supply of labor and raises real
wage of the workers who remain there.

- Workers who start in the Home country earn more due to emigration
regardless if they are among those who leave.

- Immigration into Foreign increases the supply of labor and decreases

the real wage there.

• Wages do not actually equalize, due to barriers to migration such

as policies restricting immigration and natural reluctance to move.
Fig. 4-13: Causes and Effects of
International Labor Mobility
International Labor Mobility
(cont.)

• Labor migration increases world output.

- The value of foreign output rises by the area under its MPL*
curve from L1 to L2
- The value of domestic output falls by the area under its
MPL curve from L2 to L1
- World output rises because labor moves to where it is more
productive (where wages are higher).
- The value of world output is maximized when the marginal
productivity of labor is the same across countries.
International Labor Mobility
(cont.)

• Workers initially in Home benefit while workers in Foreign

are hurt by inflows of other workers.

- Landowners in Foreign gain from the inflow of workers

decreasing real wages and increasing output.

- Landowners in Home are hurt by the outflow of

workers increasing real wages and decreasing output.
International Labor Mobility
(cont.)

• Does migration lead to the wage changes predicted?

• Table 4-1 shows that real wages in 1870 were much

higher in destination countries than in origin
countries.
• Up until the eve of World War I in 1913, wages rose
faster in origin countries than in destination
countries (except Canada).
• Migration moved the world toward more equalized
wages.
Table 4-1
International Labor Mobility
(cont.)

• In the early 20th century, share of immigrants in the U.S.

increased dramatically.
- Vast immigration from Eastern and Southern Europe.
• Tight restrictions on immigration imposed in the 1920s.
- Immigrants were a minor force in the U.S. by the 1960s.
• New wave of immigration began around 1970.
- Mostly from Latin America and Asia.
• As of 2006, 15.3% of the U.S. labor force foreign-born.
Fig. 4-14: Immigrants as a Percentage of
the U.S. Population
Immigration and the U.S.
Economy
• The largest increase in recent immigration occurred
among workers with the lowest education levels,
making less educated workers more abundant.

- possibly reduced wages for native-born workers

with low education levels while raising wages for the
more educated

- widening wage gap between less educated workers

and highly educated workers.
Summary

1. International trade often has strong effects on the

distribution of income within countries -- produces
losers as well as winners.
2. Income distribution effects arise for two reasons:
- Factors of production cannot move costlessly and quickly
from one industry to another.
- Changes in an economy’s output mix have differential
effects on the demand for different factors of production.
Summary (cont.)

3. International trade affects the distribution of

income in the specific factors model.
- Factors specific to export sectors in each country
gain from trade, while factors specific to import-
competing sectors lose.
- Mobile factors that can work in either sector may
either gain or lose.
Summary (cont.)

4. Trade nonetheless produces overall gains in the

sense that those who gain could in principle
compensate those who lose while still remaining
better off than before.
5. Most economists would prefer to address the
problem of income distribution directly, rather
than by restricting trade.
6. Those hurt by trade are often better organized
than those who gain, causing trade restrictions
to be adopted.
 Summary (cont.)

7. Labor migrates to countries with higher labor productivity

and higher real wages, where labor is scarce.
- Real wages fall due to immigration and rise due to emigration.
- World output increases.

8. Real wages across countries are far from equal due to

differences in technology and due to immigration barriers.
 Chapter 4

Appendix:
Further Details on Specific
Factors
Fig. 4A-1: Showing that Output Is Equal to the
Area Under the Marginal Product Curve
Fig. 4A-2: The Distribution of
Income Within the Cloth Sector
Fig. 4A-3: A Rise in PC Benefits the Owners
of Capital
Fig. 4A-4: A Rise in PC Hurts Landowners