International economic ch03

Chapter 3Chapter 3
Specific Factors and Income DistributionSpecific Factors and Income Distribution
Prepared by Iordanis Petsas
To Accompany
International Economics: Theory and PolicyInternational Economics: Theory and Policy, Sixth Edition
by Paul R. Krugman and Maurice Obstfeld

 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

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 they
demand.
 The specific factors model allows trade to affect
income distribution.

 Assumptions of the Model
• Assume that we are dealing with one economy that can produce
two goods, manufactures and food.
• There are three factors of production; labor (L), capital (K) and
land (T for terrain).
• Manufactures are produced using capital and labor (but not
land).
• Food is produced using land and labor (but not capital).
– Labor is therefore a mobile factor that can be used in either
sector.
– Land and capital are both specific factors that can be used
only in the production of one good.
• Perfect Competition prevails in all markets.
The Specific Factors Model

• How much of each good does the economy produce?
– The economy’s output of manufactures depends on how
much capital and labor are used in that sector.
• This relationship is summarized by a production
function.
• The production function for good X gives the maximum
quantities of good X that 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).

• The production function for manufactures is given by
QM = QM(K, LM) (3-1)
where:
– QM is the economy’s output of manufactures
– K is the economy’s capital stock
– LMis the labor force employed in manufactures
• The production function for food is given by
QF = QF(T, LF) (3-2)
where:
– QF is the economy’s output of food
– T is the economy’s supply of land
– LF is the labor force employed in food

• The full employment of labor condition requires that
the 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 production
possibilities frontier of the economy.

 Production Possibilities
• To analyze the economy’s production possibilities, we
need only to ask how the economy’s mix of output
changes as labor is shifted from one sector to the other.
• Figure 3-1 illustrates the production function for
manufactures.

QM = QM (K, LM)
Figure 3-1: The Production Function for Manufactures
Labor input, LM
Output, QM

• 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 will add less to the
production of output than the last.
• Figure 3-2 shows the marginal product of labor, which
is the increase in output that corresponds to an extra unit
of labor.

MPLM
Figure 3-2: The Marginal Product of Labor
Labor input, LM
Marginal product
of labor, MPLM

QF =QF(K, LF)
QM =QM(K, LM)
L2
M
L2
F
3
2
1
L
L
AA
1'
3'
PP
Economy’s production
possibility frontier (PP)
Production function
for manufactures
Economy’s allocation
of labor (AA)
Production function
for food
Q2
F
Q2
M
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

 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 of
employing that hour.

• The demand curve for labor in the manufacturing
sector can be written:
MPLM x PM = w (3-4)
– The wage equals the value of the marginal product of
labor in manufacturing.
• The demand curve for labor in the food sector can be
written:
MPLF x PF = w (3-5)
– The wage rate equals the value of the marginal
product of labor in food.

 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)

PM X MPLM
(Demand curve for labor in
manufacturing)
PF X MPLF
(Demand curve
for labor in food)
Wage rate, W
Wage rate, W
W1
1
L1
M L1
F
Total labor supply, L
Labor used in
manufactures, LM
Labor used
in food, LF
Figure 3-4: The Allocation of Labor

 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)

Slope = -(PM /PF)1
1
Q1
F
Q1
M
Output of manufactures, QM
Output of food, QF
PP
Figure 3-5: Production in the Specific Factors Model

• What happens to the allocation of labor and the
distribution of income when the prices of food and
manufactures change?
• Two cases:
– An equal proportional change in prices
– A change in relative prices

W1 1
PF increases
10%
Wage rate, W
Wage rate, W
PF
1
X MPLF
Labor used in
manufactures, LM
Labor used
in food, LF
10%
wage
increase
PM
increases
10%
PM
1
X MPLM
W2
2
PF
2
X MPLF
PM
2
X MPLM
Figure 3-6: An Equal Proportional Increase in the Prices of Manufactures and Food

• 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.

• When only PM rises, labor shifts from the food sector to
the manufacturing sector and the output of
manufactures rises while that of food falls.
• The wage rate (w) does not rise as much as PMsince
manufacturing employment increases and thus the
marginal product of labor in that sector falls.

PF
1
X MPLF
Wage rate, W
Wage rate, W
PM
1
X MPLM
2
W 2
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
PM
2
X MPLM
1
W 1
Figure 3-7: A Rise in the Price of Manufactures

PP
Slope = - (PM /PF)1
Output of
manufactures, QM
Output of food, QF
Slope = - (PM /PF) 2
1
Q1
F
Q1
M
2
Q2
F
Q2
M
Figure 3-8: The Response of Output to a Change in the
Relative Price of Manufactures

Relative quantity
of manufactures, QM/QF
Relative price
of manufactures, PM /PF
RD
RS
Figure 3-9: Determination of Relative Prices
1
(PM /PF )1
(QM /QF )1

 Relative Prices and the Distribution of Income
• Suppose that PM increases by 10%. Then, we would
expect the wage to rise by less than 10%, say by 5%.
• What is the economic effect of this price increase on
the incomes of the following three groups?
– Workers
– Owners of capital
– Owners of land

• 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.

 Assumptions of the model
• Assume that both countries (Japan and America) have
the same relative demand curve.
• Therefore, the only source of international trade is the
differences in relative supply. The relative supply might
differ because the countries could differ in:
– Technology
– Factors of production (capital, land, labor)
International Trade
in the Specific Factors Model

 Resources and Relative Supply
• What are the effects of an increase in the supply of
capital stock on the outputs of manufactures and food?
– A country with a lot of capital and not much land will
tend to produce a high ratio of manufactures to food at
any given prices.
International Trade

PM X MPLM
2
PF
1
X MPLF
Wage rate, W
Wage rate, W
PM X MPLM
1
W 1
1
2
W 2
Increase
in capital
stock, K
Amount of labor
shifted from food to
manufactures
Labor used in
manufactures, LM
Labor used
in food, LF
International Trade
Figure 3-10: Changing the Capital Stock

• An increase in the supply of capital would shift the
relative supply curve to the right.
• An increase in the supply of land would shift the
relative 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

 Trade and Relative Prices
• Suppose that Japan has more capital per worker than
America, while America has more land per worker
than Japan.
– As a result, the pretrade relative price of manufactures
in Japan is lower than the pretrade relative price in
America.
• International trade leads to a convergence of relative
prices.
International Trade

Relative quantity of
manufactures, QM/QF
Relative price of
manufactures, PM /PF
(PM /PF )W
(PM /PF )A
(PM /PF )J
International Trade
Figure 3-11: Trade and Relative Prices
RDWORLD
RSA
RSWORLD
RSJ

 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 of
manufactures and food consumed to differ from the
mix produced.
• A country cannot spend more than it earns.
International Trade

Budget constraint
(slope = -PM/PF)
Consumption of manufactures, DM
Consumption of food, DF
Output of food, QF
Production possibility curve
International Trade
Figure 3-12: The Budget Constraint for a Trading Economy
Q1
M
1
Q1
F

QJ
F
QA
F
DA
F
DJ
F
QA
M DA
M
QJ
MDJ
M
Japan’s
food
imports
America’s
food
exports
Japan’s
manufactures
exports
America’s
manufactures
imports
Quantity of
manufactures
Quantity of
manufactures
Quantity of
food
Quantity of
food
Japanese budget constraint American budget constraint
International Trade
Figure 3-13: Trading Equilibrium

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.

 Could those who gain from trade compensate those
who lose, and still be better off themselves?
• If so, then trade is potentially a source of gain to
everyone.
 The fundamental reason why trade potentially
benefits a country is that it expands the economy’s
choices.
• This expansion of choice means that it is always
possible to redistribute income in such a way that
everyone gains from trade.

Budget constraint
(slope = - PM/PF)
PP
Consumption of manufactures, DM
Consumption of food, DF
Output of food, QF
Q1
M
Q1
F
1
2
Figure 3-14: Trade Expands the Economy’s Consumption Possibilities

 Trade often produces losers as well as winners.
 Optimal Trade Policy
• The government must somehow weigh one person’s
gain against another person’s loss.
– Some groups need special treatment because they are
already relatively poor (e.g., shoe and garment workers
in 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 of
policy.
The Political Economy of Trade:
A Preliminary View

 Income Distribution and Trade Politics
• 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
The Political Economy of Trade:
A Preliminary View

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 instantaneously
and costlessly from one industry to another.
• Changes in an economy’s output mix have
differential effects on the demand for different
factors of production.

Summary
 A useful model of income distribution effects of
international trade is the specific-factors model.
• In this model, differences in resources can cause
countries to have different relative supply curves, and
thus cause international trade.
• 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
 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.

dLM
MPLM
Figure 3A-1: Showing that Output Is Equal to the Area Under the
Marginal Product Curve
Appendix:
Further Details on Specific Factors
Labor input, LM
Marginal Product of
Labor, MPLM

Wages
w/PM
Income of
capitalists
Appendix:
Figure 3A-2: The Distribution of Income Within
the Manufacturing Sector
MPLM
Labor input, LM
Marginal Product of
Labor, MPLM

Increase in
capitalists’ income
(w/PM)1
(w/PM)2
MPLM
Labor input, LM
Marginal Product of
Labor, MPLM
Figure 3A-3: A Rise in PM Benefits the Owners of Capital
Appendix:

Decline in landowners’
income
(w/PF)2
(w/PF)1
Labor input, LF
Marginal Product of
Labor, MPLF
Appendix:
Figure 3A-4: A Rise in PM Hurts Landowners
MPLF

International economic ch03

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