Feenstra Taylor Econ CH03

GAINS AND LOSSES FROM TRADE IN THE SPECIFIC-

FACTORS MODEL

1 Specific-Factors

Model 2

Earnings of Labor 3

Earnings of Capital and Land

4Conclusions

3

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.

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.


• 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).


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. Suppose one unit of L moves from Agriculture to

Manufacturing: agricultural output falls by MPLA and manufacturing output rises by MPLM.

Thus, 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.


Figure 3.3

Production Possibilities Frontier


• 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.

MM MPLPW


• Opportunity Cost and Prices

The value of the additional output can be measured by multiplying the price of the good times the additional output, or the MPL.

This equality holds for both industries:

AA

MM

MPLPW

MPLPW


• 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).

M

A

A

M

AAMM

PML

PML

P

P

PMLPMPLP


• The no-trade position for Home is shown on the next slide at point A

• In equilibrium PM/PA = −(slope of PPF) = −(slope of indifference curve)

The indifference curve is tangent to PPF


U1

Manufacturing Output, QM

A

B

Agriculture Output, QA

PPF

Slope = –(PM/PA)

Home Country without Trade


• 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


Slope = –(PM/PA)W

U1

Manufacturing Output, QM

A

B

Agriculture Output, QA

PPF

Slope = –(PM/PA)

Home Country with Trade

C

U2

Gains from trade

The gains from trade can be measured by the rise in utility from U1 to U2.

Trade makes prices for manufacturing in Home rise as seen from new price line

Once trade is opened and consumers face the new world price, they are able to move to a higher indifference curve (U2)


• 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).


Old production = ANew production = BOld consumption = ANew consumption = C


• Conclusions

The good whose relative price increases becomes the exported good.

The good whose relative price decreases is the imported good.

A country can never be made worse off from trade.

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

LLL AM

Earnings of Labor

• Determination of Wages

Firms hire up to the point where wages equal the value of the marginal product.

We can graph PM ∙ MPLM and PA ∙ MPLA in figure 3.5.

Note that PA ∙ MPLA slopes upward because LA is measured from the right.

The equilibrium wage is at these curves’ intersection at point A.

As long as wages are equal in the two sectors, there is no reason for labor to move between sectors.

Earnings of Labor

Wage

Wage

Manufacturing labor

Agriculture laborTotal labor

supply

L

0L L L0 AAMM

PM*MPLM is drawn from left to right

PM MPLM

Value of marginal product of manufacturing

PAMPLA

Value of marginal product of agriculture

PA*MPLA is drawn from right to left

A

Labor market equilibrium

W

Labor Market Equilibrium is where the two curves cross

Allocation of Labor between Manufacturing and Agriculture

Figure 3.5

Earnings of Labor

• Change in Relative Price of Manufactures Assume the relative price of manufactures rises

(because of the foreign demand for them). We have already shown the shift from no-trade to trade

equilibrium on the PPF. Now we can look at the changes in the wage in each

industry and how these changes affect the real earnings of labor.

We will subsequently look at the real earnings of land and capital owners.

Earnings of Labor

• Effect of Wage

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

Figure 3.6

B

PM'MPLM

Earnings of Labor

Wage Wage

PMMPLM

PAMPLA

A

W

L

0L LL L0 AAMM

PM*MPLM shifts up creating a new equilibrium.

W’

Vertical distance= PM (MPLM)

ΔW

The vertical distance between the old and new curves is greater than the increase in wages.

Increase in the Price of Manufactured Goods

Figure 3.6

Earnings of Labor

• Effect on Real Wages

Do higher wages translate into higher real wages? Depends on changes in prices.

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?

Earnings of Labor

• Effect on Real Wages We showed in figure 3.6 that

ΔW < ΔPM·MPLM

If we divide both sides by W we get:

ΔW/W is the percentage change in wages

M

M

MM

MM

P

P

MPLP

MPLP

W

W

Earnings of Labor

• Effects on Real Wages

ΔPM/PM is the percentage change in the price of manufactured goods.

Since ΔW/W is a smaller increase, 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

• Overall Impact on Labor Is labor better off 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.

In the specific-factors model, 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.

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

APPLICATION

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.

APPLICATION


APPLICATION


APPLICATION


• Conclusions1. 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


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

Job Losses in Manufacturing and Service Industries, 2003–2005


• 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. Total revenue is price times the quantity sold, and

payments to labor are wages times quantity hired.


• Determining the Payment to Capital and Land Payments to capital = PM·QM – W·LM

Payments to labor = PA·QA – W·LA

Taking the payments one step further will be useful. Quantity of land used in agriculture is T acres. Quantity of capital used in manufacturing is K.

We can now determine the earnings of capital, RK, and land, RT

T

WLQP

T

landtoPaymentsR

K

WLQP

K

capitaltoPaymentsR

AAAT

MMMK


• Determining the Payment to Capital and Land RK and RT are the rental rates on capital and land respectively,

which 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.

We can also use another method to calculate the rental on capital and land.

We can consider the value of the additional output we get from hiring those factors.

AAT

MMK

MPTPR

MPKPR


• 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.


• 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, in percentage terms.

Also remember RK/PA is amount of food that can be purchased by capital owners. RK increased, PA fixed, so RK/PA increases.

Real rental on capital is the amount of food that can be increased


• Change in the Real Rental on Capital

Since capital owners can afford more of both goods, they are better off when PM rises.

This is unlike the case of labor, which could buy more of one good but less of the other.

The owners of capital are clearly better off under trade than in the no-trade case.


• Change in the Real Rental on Land Labor leaves agriculture, causing MPKA to fall.

Since MPKA = RT/PA, RT/PA must fall, meaning RT itself must fall (since PA remains constant).

This means the real rental on land in terms of food has decreased—landowners cannot buy as much food.

And PM has increased, so landowners cannot buy as much of the manufactured good either.

Landowners are clearly worse off with trade than in the no-trade case.


• Summary

Real earnings of capital owners and landowners move in opposite directions. 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.

This means that, 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 = QLA = $50 Payments to Land = RTT = $50

• Assume PM increases by 10% and PA remains unchanged. Percentage change in labor 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 on Capital

KR

WLWWQPPP

R

R

K

WLQPR

K

WLQP

K

CapitaltoPaymentsR

K

MMMMM

K

K

MMMK

MMMK

:gives changes percentage using Rewriting

Numerical Example

• Change in the Rental on Capital

ΔRK/R = (10%*100-5%*60)/40 = 17.5%

The percentage increase in rental on capital is greater than 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 on Land Using the same analysis, we can look at how rental

rates are affected by an increase in PM

We know that wages are increasing which means the rental on land is falling. We can calculate how much.

T

WLQR AAT

)(0

Numerical Example

• Change in Rental on Land• Land rent falls by same percentage as

wage increases. This occurs because we assumed labor and

land received the same share of sales revenue

%550

50%5

T

T

T

A

T

T

R

R

TR

WL

W

W

R

R


• 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:

K

K

M

M

T

T

R

R

P

P

W

W

R

R

0


• 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?

0K A T

K A T

R W P RR W P R

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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Feenstra Taylor Econ CH03