Feenstra_Taylor_Econ_CH03

3
GAINS AND LOSSES 1

Specific-Factors
FROM TRADE IN Model
THE SPECIFIC- 2
Earnings of Labor
FACTORS MODEL 3
Earnings of
Capital and Land
4
Conclusions
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 2 of 63

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

• 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.

• Assumptions: Will continue to use two countries:

Home and Foreign.
• Two industries- Agriculture and Manufacturing
• 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 countries, two good, three factor model
(2*2*3) model.

Diminishing Marginal Product of Labor
Figure 3.2

• 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.


• 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.
 -∆QA/ ∆QM = -MPLA/MPLM = PM/PA
 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.
W PM MPLM
W PA MPLA

• 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

Home Country without Trade
Agriculture
Output, QA
A
U1
Slope = –(PM/PA)
B
PPF
Manufacturing
Output, QM

• 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).

• 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

Home Country with Trade
Agriculture
Output, QA
Once
Trade trade
makesis opened
prices and
for
The gains from
consumers faceintrade
the can be
new
Slope = –(PM/PA)W manufacturing
measured by the Home
rise in rise
utility
world price,
as seen fromtheynewareprice
ableline
to
from U
move to to U .
1 a higher
2 indifference
C
curve (U2)
A U2
Gains from trade
U1
Slope = –(PM/PA)
B
PPF
Manufacturing
Output, QM

• 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.

Old production = A
New production = B
Old consumption = A
New consumption = C

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.
LM  LA L
 Labor used in manufacturing is measured from the left axis.
 Labor used in agriculture is measured from the right axis.
 See Figure 3.5

Earnings of Labor
Allocation of Labor between
Manufacturing and Agriculture P
Labor Market
A*MPL A is drawn from
PEquilibrium
M*MPLM is drawn from
is where
right
left
thetotoright
two left
curves cross
Labor
market
Wage Wage
equilibrium
PAMPLA
Value of
marginal
product of
agriculture
A
W
Value of
PM MPLM marginal
product of
manufacturing
0M L  L  L 0
    M                  A   A
L
Manufacturing Agriculture
labor
Total labor
labor Figure 3.5
supply

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
Earnings of Labor
Figure 3.6 Increase in the Price of The vertical distance

PM*MPLM shifts up creating
Manufactured Goods between the old and new
a new equilibrium.
curves is greater than the
increase in wages.
Wage Vertical Wage
distance
= PM (MPLM)
PAMPLA
B
W’
ΔW PM'MPLM
W
A
PMMPLM
0M L  L L L 0
    M                  A   A
L

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:

W PM MPLM PM
 
W PM MPLM PM

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.

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.
 The conclusion that we cannot tell whether workers are better off or worse off
from the opening of trade in the specific-factors model might seem wishy-
washy to you, but it is important for several reasons
• 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 than they are in the
absence of trade.
 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.

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

Manufacturing and Services in the US
APPLICATION
• 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.

APPLICATION

APPLICATION

APPLICATION
• Conclusions
1. Wages differ across different sectors in the economy,
so the assumption that wages are the same in both
industries is a simplification.
2. 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
3. The majority of workers find new jobs within 2–3 years,
but not necessarily at the same wage
4. Real wages for all production workers fell in most
years between 1972–95, but have since risen.

APPLICATION
Job Losses in Manufacturing and Service Industries, 2003–2005
Source: U.S. Bureau of Labor Statistics, http://www.bls.gov/news.release/disp.nr0.htm

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.

 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
Payments to capital PM QM  WLM

RK  
K K
Payments to land PAQA  WL A
RT  
T T


 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.
RK PM MPK M
RT PA MPTA
• 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.

 Change in the Real Rental on Capital
 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.

• Change in the Real Rental Rate on Land
 Labor leaves agriculture, causing MPTA to fall.
 Since MPTA = 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.

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 = WLA = $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.

Numerical Example
• Change in the Rental Rate on Capital

Payments to Capital PM QM  WLM
RK  
K K
PM QM  WLM
RK 
K
Rewriting using percentage changes gives :
RK PM PM PM QM  W W WLM

RK RK K

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.

Numerical Example
• Change in Rental Rate on Land

0(QA )  WL A
RT 
T
 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%

• General Equation for the Change in Factor Prices

 We can see how all the changes in factor and industry
prices are related.
 Assume PM increases and PA does not change, then:
RT W PM RK

0  
RT W PM RK

• 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?
RK W PA RT

0  
RK W PA RT

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.

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3

GAINS AND LOSSES 1

• Opening a country to trade generates winners and

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 2 of 63

• So what we really want to know is how changes in

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 3 of 63

• Why are we concerned with relative prices?

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 4 of 63

• Assumptions: Will continue to use two countries:

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 5 of 63

Diminishing Marginal Product of Labor

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 7 of 63

• Each country faces a standard Production

 The slope of the PPF is the negative of the ratio of the

 If L continues to move to manufacturing, MPLA rises

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 8 of 63

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 9 of 63

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 10 of 63

• Since we assume that labor is mobile, the wages in

• Relative price of manufacturing equals the

• The no-trade equilibrium for Home is shown on the

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 11 of 63

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 12 of 63

 Assume the no-trade price in the foreign country (PM*/PA*) is

 For now we will ignore reasons for price differences.

 Home country has comparative advantage in manufacturing

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 13 of 63

 When trade opens the world price will end up

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 14 of 63

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 15 of 63

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 16 of 63

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 17 of 63

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 18 of 63

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 19 of 63

• Change in Relative Price of Manufactures

 A rise in relative price of manufacturing can be

 Effect on real wage is the same.

Figure 3.6 Increase in the Price of The vertical distance

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 21 of 63

 We assumed PA did not change so W/PA has increased—

 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 22 of 63

• Effects on Real Wages

 Since ΔW/W < ΔPM/PM, the amount of manufactured

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 23 of 63

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 24 of 63

 Even if we were to consider the spells of unemployment due to

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 25 of 63

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 26 of 63

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 27 of 63

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 28 of 63

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 29 of 63

Source: U.S. Bureau of Labor Statistics, http://www.bls.gov/news.release/disp.nr0.htm

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 30 of 63

• Although there are “overall” gains from trade for

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 31 of 63

 Let T denote land and K denote capital.

 We can now determine the earnings of capital, RK, and

Payments to capital PM QM  WLM

 Assume the no-trade price in the foreign country (PM/PA) is