paul krugman EI.ppt

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Chapter 3

Specific Factors and Income Distribution

Prepared byIordanis Petsas

To Accompany

International Economics: Theory and Policy, Sixth Edition

byPaul R. Krugman and Maurice Obstfeld


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Slide 3-2Copyright 2003 Pearson Education, Inc.

Introduction

The Specific Factors Model

International Trade in the Specific Factors Model

Income Distribution and the Gains from Trade

The Political Economy of Trade: A Preliminary View

Summary

Appendix: Further Details on Specific Factors

Chapter Organization


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Introduction

Trade has substantial effects on the income

distribution within each trading nation.

There are two main reasons why international trade

has strong effects on the distribution of income: Resources cannot move immediately or costlessly

from one industry to another.

Industries differ in the factors of production theydemand.

The specific factors modelallows trade to affect

income distribution.


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Assumptions of the Model

Assume that we are dealing with one economy that can producetwo goods, manufactures and food.

There are three factors of production; labor (L), capital (K) andland (Tfor terrain).

Manufactures are produced using capital and labor (but notland).

Food is produced using land and labor (but not capital).

Labor is therefore a mobile factor that can be used in eithersector.

Land and capital are both specific factors that can be usedonly in the production of one good.

Perfect Competition prevails in all markets.



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How much of each good does the economy produce?The economys output of manufactures depends on how

much capital and labor are used in that sector.

This relationship is summarized by a productionfunction.

Theproduction function for goodXgives the maximumquantities of goodXthat a firm can produce with

various amounts of factor inputs.For instance, the production function for manufactures

(food) tells us the quantity of manufactures (food) that can

be produced given any input of labor and capital (land).



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The production function for manufactures is given byQM= QM (K,LM) (3-1)

where:

QM

is the economys output of manufactures

Kis the economys capital stock

LMis the labor force employed in manufactures

The production function for food is given by

QF= QF (T,LF) (3-2)where:

QFis the economys output of food

Tis the economys supply of land

LFis the labor force employed in food



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The full employment of labor condition requires thatthe economy-wide supply of labor must equal the labor

employed in food plus the labor employed in

manufactures:

LM+LF = L (3-3)

We can use these equations and derive the productionpossibilities frontierof the economy.



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Production Possibilities

To analyze the economys production possibilities, weneed only to ask how the economys mix of output

changes as labor is shifted from one sector to the other.

Figure 3-1 illustrates the production function for

manufactures.



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QM= Q

M(K,LM)

Figure 3-1: The Production Function for Manufactures


Labor input, LM

Output,QM


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The shape of the production function reflects the law ofdiminishing marginal returns.

Adding one worker to the production process (without

increasing the amount of capital) means that each workerhas less capital to work with.

Therefore, each additional unit of labor will add less to the

production of output than the last.

Figure 3-2 shows the marginal product of labor,whichis the increase in output that corresponds to an extra unit

of labor.



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MPLM

Figure 3-2: The Marginal Product of Labor


Labor input, LM

Marginal product

of labor, MPLM


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QF

=QF(K,L

F)

QM

=QM(K,L

M)

L

2M

L2F

32

1

AA

1'

3'

PP

Economys production

possibility frontier (PP)

Production function

for manufacturesEconomysallocation

of labor (AA)

Production function

for food

Q2F

Q2M

2'

Labor input in

food, LF

(increasing )

Output of

manufactures, QM

(increasing )

Labor input

in manufactures,LM(increasing )

Output of food,

QF(increasing )

Figure 3-3: The Production Possibility Frontier in the Specific Factors Model



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Prices, Wages, and Labor Allocation

How much labor will be employed in each sector?To answer the above question we need to look at supply

and demand in the labor market.

Demand for labor:In each sector, profit-maximizing employers will

demand labor up to the point where the value produced

by an additional person-hour equals the cost ofemploying that hour.



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The demand curve for labor in the manufacturingsector can be written:

MPLMxPM= w (3-4)

The wage equals the value of the marginal product oflabor in manufacturing.

The demand curve for labor in the food sector can be

written:MPLF

xPF= w (3-5)

The wage rate equals the value of the marginal

product of labor in food.



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The wage rate must be the same in both sectors,

because of the assumption that labor is freely

mobile between sectors.

The wage rate is determined by the requirement

that total labor demand equal total labor supply:

LM+LF=L (3-6)



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PMXMPL

M

(Demand curve for labor in

manufacturing)

PFXMPL

F

(Demand curvefor labor in food)

Wage rate, WWage rate, W

W1

1

L1M L 1

F

Total labor supply, L

Labor used in

manufactures, LMLabor used

in food, LF

Figure 3-4: The Allocation of Labor



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At the production point the production possibility

frontier must be tangent to a line whose slope is

minus the price of manufactures divided by that of

food.

Relationship between relative prices and output:

-MPLF/MPLM= -PM/PF (3-7)



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Slope = -(PM

/PF)1

1Q1

F

Q1M Output of manufactures, QM

Output of food, QF

PP

Figure 3-5: Production in the Specific Factors Model



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What happens to the allocation of labor and thedistribution of income when the prices of food and

manufactures change?

Two cases:An equal proportional change in prices

A change in relative prices



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W1 1

PFincreases10%


PF1XMPL

F

Labor used in

manufactures, LM

Labor used

in food, LF

10%

wage

increase

PM

increases10%

PM1XMPL

M

W22

PF2XMPL

F

PM2XMPL

M

Figure 3-6: An Equal Proportional Increase in the Prices of Manufactures and Food



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When both prices change in the same proportion, noreal 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.



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When onlyPMrises, labor shifts from the food sectorto the manufacturing sector and the output of

manufactures rises while that of food falls.

The wage rate (w) does not rise as much asPMsincemanufacturing employment increases and thus the

marginal product of labor in that sector falls.



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PF1XMPL

F


PM1XMPL

M

2W2

Labor used

in food, LF

Labor used in

manufactures, LM Amount of labor

shifted from food

to manufactures

Wage

rate

rises by

less than

7%

7%

upward

shift in

labor

demand

PM2XMPL

M

1W1

Figure 3-7: A Rise in the Price of Manufactures



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PP

Slope = - (PM/P

F)1

Output of

manufactures, QM

Output of food, QF

Slope = - (PM/P

F) 2

1

Q1F

Q1M

2Q2

F

Q2M

Figure 3-8: The Response of Output to a Change in theRelative Price of Manufactures



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Relative quantity

of manufactures, QM/QF

Relative price

of manufactures, PM/P

F

RD

RS

Figure 3-9: Determination of Relative Prices

1(P

M/P

F

)1

(QM/Q

F

)1



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Relative Prices and the Distribution of Income

Suppose thatPMincreases by 10%. Then, we wouldexpect the wage to rise by less than 10%, say by 5%.

What is the economic effect of this price increase onthe incomes of the following three groups?

Workers

Owners of capital

Owners of land



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Workers:We cannot say whether workers are better or worse off;

this depends on the relative importance of manufactures

and food in workers consumption.

Owners of capital:They are definitely better off.

Landowners:They are definitely worse off.



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Assumptions of the model

Assume that both countries (Japan and America) havethe same relative demand curve.

Therefore, the only source of international trade is thedifferences in relative supply. The relative supply might

differ because the countries could differ in:

Technology

Factors of production (capital, land, labor)

in the Specific Factors Model

International Trade


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Resources and Relative Supply

What are the effects of an increase in the supply ofcapital stock on the outputs of manufactures and food?

A country with a lot of capital and not much land willtend to produce a high ratio of manufactures to food at

any given prices.

International Trade


International Trade


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PMXMPL

M2

PF1XMPL

F


PMXMPL

M1

W11

2W2

Increase

in capital

stock, K

Amount of labor

shifted from food tomanufactures

Labor used in

manufactures, LM

Labor used

in food, LF

International Trade


Figure 3-10: Changing the Capital Stock

International Trade


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An increase in the supply of capital would shift therelative supply curve to the right.

An increase in the supply of land would shift therelative supply curve to the left.

What about the effect of an increase in the labor force?The effect on relative output is ambiguous, although

both outputs increase.

International Trade


International Trade


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Trade and Relative Prices

Suppose that Japan has more capital per worker thanAmerica, while America has more land per workerthan Japan.

As a result, the pretrade relative price of manufacturesin Japan is lower than the pretrade relative price inAmerica.

International trade leads to a convergence of relativeprices.

International Trade


International Trade


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Relative quantity of

manufactures, QM/Q

F

Relative price of

manufactures, PM/P

F

(PM/P

F)W

(PM

/PF

)A

(PM

/PF

)J

International Trade


Figure 3-11: Trade and Relative Prices

RDWORLD

RSA

RSWORLD

RSJ

International Trade


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The Pattern of Trade In a country that cannot trade, the output of a good

must equal its consumption.

International trade makes it possible for the mix ofmanufactures and food consumed to differ from the

mix produced.

A country cannot spend more than it earns.

International Trade


International Trade


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Budget constraint

(slope = -PM/PF)

Consumption of manufactures, DM

Output of manufactures, QM

Consumption of food, DF

Output of food, QF

Production possibility curve

International Trade


Figure 3-12: The Budget Constraint for a Trading Economy

Q1M

1Q1

F

International Trade


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QJF

QAF

DAF

DJF

QAMDA

MQ

JMDJ

M

Japans

food

imports

Americas

food

exports

Japans

manufactures

exports

Americas

manufactures

imports

Quantity of

manufactures

Quantity of

manufactures

Quantity of

foodQuantity of

food

Japanese budget constraint American budget constraint

International Trade


Figure 3-13: Trading Equilibrium

Income Distrib tion and


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Income Distribution and

the Gains from Trade

To assess the effects of trade on particular groups, the

key point is that international trade shifts the relative

price of manufactures and food.

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.



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Could those who gain from trade compensate thosewho lose, and still be better off themselves?

If so, then trade is potentially a source of gain toeveryone.

The fundamental reason why trade potentiallybenefits a country is that it expands the economyschoices.

This expansion of choice means that it is alwayspossible to redistribute income in such a way thateveryone gains from trade.





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Budget constraint

(slope = - PM

/PF)

PP

Consumption of manufactures, DM

Output of manufactures, QM

Consumption of food, DF

Output of food, QF

Q1M

Q1F

1

2

Figure 3-14: Trade Expands the Economys Consumption Possibilities



The Political Economy of Trade:


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Trade often produces losers as well as winners.

Optimal Trade Policy

The government must somehow weigh one personsgain against another persons loss.

Some groups need special treatment because they arealready relatively poor (e.g., shoe and garment workersin the United States).

Most economists remain strongly in favor of more or

less free trade. Any realistic understanding of how trade policy is

determined must look at the actual motivations ofpolicy.


A Preliminary View



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Income Distribution and Trade Politics

Those who gain from trade are a much lessconcentrated, informed, and organized group than

those who lose.Example: Consumers and producers in the U.S. sugar

industry


A Preliminary View


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Summary

International trade often has strong effects on the

distribution of income within countries, so that it

often produces losers as well as winners.

Income distribution effects arise for two reasons:

Factors of production cannot move instantaneouslyand costlessly from one industry to another.

Changes in an economys output mix havedifferential effects on the demand for different

factors of production.


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Summary

A useful model of income distribution effects ofinternational trade is the specific-factors model.

In this model, differences in resources can causecountries to have different relative supply curves, and

thus cause international trade.

In the specific factors model, factors specific to exportsectors in each country gain from trade, while factorsspecific to import-competing sectors lose.

Mobile factors that can work in either sector mayeither gain or lose.


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Summary

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.

Appendix:


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dLM

MPLM

Figure 3A-1: Showing that Output Is Equal to the Area Under theMarginal Product Curve

Appendix:

Further Details on Specific Factors

Labor input, LM

Marginal Product of

Labor, MPLM

Appendix:


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Wages

w/PM

Income of

capitalists

Appendix:


Figure 3A-2: The Distribution of Income Withinthe Manufacturing Sector

MPLM

Labor input, LM

Marginal Product of

Labor, MPLM

Appendix:


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Increase in

capitalists income

(w/PM

)1

(w/PM

)2

MPLM

Labor input, LM

Marginal Product of

Labor, MPLM

Figure 3A-3: A Rise inPMBenefits the Owners of Capital

Appendix:


Appendix:


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Decline in landowners

income

(w/PF)2

(w/PF)1

Labor input, LF

Marginal Product of

Labor, MPLF

Appendix:


Figure 3A-4: A Rise inPMHurts Landowners

MPLF

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