gains and losses from trade in the specific-factors model readings: chapter 3 1 specific-factors...

Gains and Losses from Trade in the Specific-Factors

ModelReadings: Chapter 3

1 Specific-Factors

Model 2

Earnings of Labor 3

Earnings of Capital and Land

4Conclusions

3

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U.S.-South Korea Free Trade Agreements

• Announced in December 3, 2010. • Tariff cuts are not uniform across sectors

• $1 billion of U.S. farm exports will become duty-free immediately

• But U.S. beef exports still faces a 40% tariff (to be phased out in 15 years)

• The U.S. tariff on auto imports (2.5%) will remain until the 5th year.

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Bolivian Politics and Trade

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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Specific-Factors Model

• Gains from trade are not evenly distributed across industries

• The specific-factor model helps explain who gain and who lose from trade

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Road Map

• Part 1 How does trade affect the Home country? Before trade With trade

• Part 2 How does trade affect real wages?• Part 3 How does trade affect the returns to

capital and land?

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Specific-Factors Model

• Home Country Manufacturing uses labor (LM) and capital (K)

Agriculture uses labor (LA) and land (T)

Labor moves freely between manufacturing and agriculture

Capital is “stuck” in manufacturing (i.e. it has NO USE in agriculture)

Land is “stuck” in agriculture (i.e. it has NO USE in manufacturing)

• Labor is the “mobile factor”• Capital and land are “specific factors”

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Diminishing Returns

• Manufacturing output and labor employment

Holding K fixed

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Diminishing Returns

Diminishing returns to labor – decreasing MPLM and MPLA

Holding K Constant

Holding TConstant

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Notes: Diminishing Returns

• Diminishing returns As more labor is used, the manufacturing output

goes up, but at a diminishing rate, holding K constant.

As more labor is used, the marginal product of labor in manufacturing, MPLM, decreases, holding K constant.

The statements for agriculture are analogous.

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PPF and Slope

PPF is concave shapedFrom A to B:Loss in QA = -MPLA

Gain in QM = MPLM

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Notes: PPF and Slope

• Each country faces a standard Production Possibilities Frontier Concave to the origin due to diminishing returns

to labor in both industries The slope of the PPF is the ratio of the marginal

products Ratio is the opportunity cost of producing one unit of

manufacturing

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Wage Equation

• Wages Firms hire labor up to the point where the marginal

benefits equal the marginal costs

This relationship holds for both industries

AA

MM

MPLPW

MPLPW

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Relative Price Before Trade

• 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 M A A

M A

A M

P MPL P MPL

P MPL

P MPL

Thus as in the Ricardian model, |slope of the PPF|= the relative price of manufacturing= the Opportunity Cost of manufactured good

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closed-economy equilibrium

U1

Manufacturing Output, QM

A

B

Agriculture Output, QA

PPF

Slope = –(PM/PA)

Home Country Before Trade

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Notes: closed-economy equilibrium

• Equilibrium for Home country is A. In equilibrium PM/PA = |slope of PPF|

Consumer’s indifference curve is tangent to PPF This is the same as in the Ricardian model

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Foreign Country

• Assume that the Foreign Country has the comparative advantage in the agricultural good; i.e. (PM*/PA*) > (PM/PA)

• Then at equilibrium with free trade, the equilibrium price (PM/PA)W falls between (PM*/PA*) and (PM/PA)

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Gains from trade

Slope = –(PM/PA)W

U1


A

B


PPF

Slope = –(PM/PA)

Figure 3.4 b – Home Country w/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 consumer face the new world price, they are able to move to a higher indifference curve (U2).

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Equilibrium with Trade

Slope = –(PM/PA)W

U1


A

B


PPF

Slope = –(PM/PA)

C

U2

Gains from trade

Old production – A

New production – B

Old consumption – A

New consumption - C

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Notes: Equilibrium with trade

• What has happened at Home? Relatively higher prices 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 move individuals to a higher indifference curve, allowing them to now consume at C (instead of A)

Home does not completely specialize in manufacturing and still produces agriculture

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Application: How Large Are Gains from Trade

• Dec. 1807 ~ Mar. 1809, the U.S. imposed an embargo (a complete halt of international trade)

• Exports (cotton, tobacco, rice, etc.) dropped from $49 M to $9 M

• Cost of embargo estimated at 5% of U.S. GDP then In the great depression, loss in output was 9% of

U.S. GDP

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Summary of Part 1

• Diminishing Returns PPF is concave-shaped Home produces manufacturing AND agriculture

with free trade (no specialization) OC changes with output and labor employment

• Many results derived for Ricardian model still work Wage = price x marginal product of labor OC = relative price before trade (comparative

advantage)

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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 (i.e. real wages) affected by trade?

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Labor Market Equilibrium

• Determination of Wages We can show the uses of labor in each industry

on one graph Uses of labor and wages are directly dependent

on the marginal product of labor Firms hire up to the point where wages equal the

value of the marginal product.

M AL L L

AA

MM

MPLPW

MPLPW

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Manufacturing

W = PMMPLM

LM

Agriculture

W = PAMPLA

LA

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PM*MPLM is drawn from left to right

PA*MPLA is drawn from right to left

Labor Market Equilibrium is where the two curves cross

PM PA K, L_bar and T Are given

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Notes: Labor Market Equilibrium

• As long as the labor market is in equilibrium, there is no reason for labor to move between sectors

• However, equilibrium can change as other factors in the markets changes

• Labor will move to the industry where it is paid (valued) more

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Effects of trade

• Change in Relative Price of Manufactures From no-trade equilibrium to trade equilibrium,

relative price of manufacturing good increases. (PM/PA)W > (PM/PA)

This can be caused by an increase in PM or a decrease in PA; effect on real wage is the same

Assume PM rises and PA does not change

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Effects of Trade

PM*MPLM shifts up creating a new equilibrium

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

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Summary: effects of trade

• Effect on Wage PM*MPLM curve shifts up by Δ PM*MPLM

New equilibrium at higher wage LM has increased and LA has decreased

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Real wages

• Home makes both mfg. and agr. With trade

W = PMW x MPLM = PA

W x MPLA

• Real wages equal marginal products of labor

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Real wage for Agr.

• LA falls,

• So MPLA rises

• So w/PA (= MPLA) rises

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Real wage for Mfg.

• LM rises,

• So MPLM falls

• So w/PM (= MPLA) falls

• i.e. wages “rises by less” than PM

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Summary: How does trade affect real wages?

• PM increases and PA does not change 0 M MA AP P W W P P

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Notes: How does trade affect real wages?

• Ambiguous We have cannot make unqualified statements

about the effect of trade on workers. The effect of trade on real wages is complex

Is labor better off or worse off after the price increase? A person who spends much of their income on

agricultural goods is probably better off and vice versa. In the specific-factors model, the overall effect on the

well-being of workers has an ambiguous effect.

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Summary: Steps We’ve Taken

• Want to see trade => real wages w• But wages depend on marginal products of

labor (e.g. W/PM = MPLM )

• Marginal products of labor, in turn, depend on labor employments (e.g. MPLM depends on LM)

• So we go

trade => LM and LA => MPLM and MPLA => real wages

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How does trade affect Unemployment?

• No effect! Total labor is always LM + LA = so no

unemploymentL

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APPLICATION

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Employment Churning in the U.S. Economy

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

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Notes: How does trade affect Unemployment?

Why do we ignore unemployment?

Unemployment usually considered a macro phenomenon affected by business cycles

Many people laid off due to trade often find new jobs in a reasonable amount of time, sometimes with higher wages

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APPLICATION

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Trade Adjustment Assistance (TAA) Program

• Unemployment Insurance (UI) Involuntary unemployment State UI agencies. Up to 26 weeks and $390 per

week in Indiana, 2008.

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APPLICATION

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Trade Adjustment Assistance (TAA) Program

• Trade Adjustment Assistance http://www.doleta.gov/tradeact/benefits.cfm After normal UI is exhausted; employment related

to foreign competition; U.S. DOL Training: up to 104 weeks income support: 26 after UI, plus 52 if training job search and relocation expenses

• TAA is a small program In 2011, total expense $300 million, 27,000

workers (source: http://en.wikipedia.org/wiki/Trade_Adjustment_Assistance#Program_Cost )

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Summary: Part 2

• Labor Market Equilibrium• How does trade affect real wages?

Changes in LA and LM

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• Although there are “overall” gains from trade for the country, we know that the effect of trade on labor earnings is ambiguous.

• What happen to owners of capital and land?

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• Determining the Payment to Capital and Land We consider the value of the additional output we

get from hiring those factors, similar to the way we derive the wage equations:

MPKM is the marginal product of capital in manufacturing

MPTA is the marginal product of land in agriculture

AAT

MMK

MPTPR

MPKPR

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Marginal Products of Capital and Land

• MPKM rises (falls) if LM rises (falls)

• MPTA rises (falls) if LA rises (falls)

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Notes: Earnings of Capital and Land

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

respectively Rental reflects 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

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Real Returns to Capital

• Capital is used in Mfg. only: RK = PM × MPKM

RK rises because (1) PM rises (2) MPKM rises (because LM rises)

• Real return in terms of Agr.: RK/PA

Rises because RK rises and PA doesn’t change

• Real return in terms of Mfg.: RK/PM = MPKM

Rises because MPKM rises (because LM rises)

Intuitively, RK “rises by more” than PM

Rigorously,

• Capital owners are better-off

M M K KP P R R

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Real Returns to Land

• Land is used in Agr. only: RT = PA × MPTA

RT falls because (1) PA doesn’t change (2) MPTA falls (because LA falls)

• Real return in terms of Mfg.: RT/PM

falls because RT falls and PM rises

• Real return in terms of Agr.: RT/PA = MPTA

falls because MPTA falls (because LA falls)

This means that

• Land owners are worse-off

0T T A AR R P P

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Intuition

• Why do capital owners benefit from trade?

(1) capital is specific to mfg. (2) interests of capital owners are tied to mfg. (3) mfg. expands with free trade

• Why do land owners lose from trade?

(1) land is specific to agr. (2) interests of land owners are tied to agr. (3) agr. contracts with free trade

• Assumptions: K and T do not change.

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Summary: Trade redistributes income

• General Equation for the Change in Factor Prices PM increases and PA does not change

KKMMTT RRPPWWRR 0

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Application: Prices in Coffee

• Price of coffee fluctuates wildly from year to year

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Application: Fair Trade Coffee

• In 1999, TransFair USA started offering fixed prices to coffee farmers in Central America, bypassing middle men

• This fair-trade coffee gained momentum following the collapse of coffee price in 2001

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Application: Fair Trade Coffee

• In 2005, however, coffee prices recovered in the world market

• The fixed price offered through fair trade arrangements was lower than the prices offered by middlemen

• Coffee growers were torn between being loyal to the fair-trade contract, and delivering to middlemen for higher earnings.

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Summary Part 3

• Rentals of capital and land Capital owners gain from trade because trade

expands mfg. (K does not change) Land owners lose from trade because trade

contracts agr. (T does not change)

• Comparison of percentage changes in PA, PM, w, RT and RK.

gains and losses from trade in the specific-factors model readings: chapter 3 1 specific-factors...

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trade slide

manufacturing labor

unit of manufacturing

earnings of labor

fixed slide

labor employment

land t labor

t constant slide