Chapter 4 International econ - Chapter 4: Specific factors and income distribution  Understand how - Studeersnel (2024)

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Chapter 4: Specific factors and income distribution

 Understand how a mobile factor will respond to price changes by moving across sectors. Explain why trade will generate both winners and losers in the short run. Understand the meaning of gains from trade when there are losers. Discuss the reasons why trade is a politically contentious issue. Explain the arguments in favor of free trade despite the existence of losers.

I. Introduction

If trade is so good why is there such an opposition? - Resources cannot move immediately or without costs from one industry to another - Industries differ in the factors of production they demand

II. The Specific Factors Model

 allows trade to affect income distribution o Assumption of the model  Two goods (e.g and food)  Three factors of production: labor (L), capital (K), land (T)  Perfect competition prevails in all markets o Food produced using land and labor (but not capital). o Labor is a mobile factor that can move between sectors. o Land and capital are both specific factors used only in the production of one good.

How much of each good does the economy produce?

• The production function for cloth gives the quantity of cloth that can be produced given any input of capital and labor: QC =QC(K L, C)

• QC is the output of cloth

• K is the capital stock

• LC is the labor forceemployed in cloth

• The production function for food gives the quantity of food that can be produced given any input of land and labor: QF=QF(T L, F)

• QF is the output of food

• T is the supply of land

• LF is the labor forceemployed in food

1. Production Possibilities:

Definition: the marginal product of labor is the change in outputthat results from employing an added unit of labor

 How does the economy’s mix of output change if labor is shiftedfrom one sector to the other one?: When labor moves from food tocloth = less production of food, more of clothing

The more labor employed in the production of cloth, the larger the output. As a result ofdiminishing returns, however, each successive person-hour increases output by less than theprevious one; this is shown by the fact that the curve relating labor input to output gets flatterat higher levels of employment.

Shape of production curve // 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 adds less output than the last.

Marginal product of labor (increase of output corresponding to an extra unit of labor):

The marginal product of labor in the cloth sector, equal to theslope of the production function shown in Figure 4, is lowerthe more labor the sector employs.

The total labor employed in food and cloth must equal the total labor supply: LC+LF =L

• Use a four-quadrant diagram to construct production possibilities frontier in Figure
  4. • Lower left quadrant indicates the allocation of labor.
     • Lower right quadrant shows the production function for cloth from Figure 4.
     • Upper left quadrant shows the corresponding production function for food.
     • Upper right quadrant indicates the combinations of cloth and food that can be produced.

PP in the upper-right quadrantshows the economy’s productionpossibilities for given supplies ofland, labor, and capital. Due todiminishing returns, PP is abowed-out curve instead of astraight line

The equilibrium wage rate and allocation of labor between the two sectors equals 1. At thewage rate w 1 ,the sum of labor demand in cloth Lc 1 and food Lf 1 equals total labor supply.

MPLc * Pc = MPLF * Pf = w (relationship between relative prices and output)

 MPLc/ MPLf = Pf/Pc  -MPLf/MpLc = -Pc/Pf

The economy produces at the point on its productionpossibility frontier (PP) where the slope of thatfrontier equals minus the relative price of cloth.

• At the production point, the production possibility frontier must be tangent to a line whose slope is minus the price of cloth divided by that of food.why??

What happens to the allocation of labor and the distribution of income when the prices of foodand cloth change? - Two cases: 1. An equal proportional change in prices - No real changes occurs: - The wage rate (w) rises in the same proportion as the prices, so real wages (i., 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.

An equal-Proportional Increase in the prices of cloth and food

2. A change in relative prices

 A rise in the price of cloth:When Pc rises, labor shifts from the food sector to the cloth sector= output of cloth rises, foodfalls

Wage rate does not rise as much as Pc since cloth employment increases thus the marginalproduct of labor in that sector falls

The cloth labor demand curverises in proportion to the 7percent increase in PC, but thewage rate rises less thanproportionately. Labor movesfrom the food sector to thecloth sector. Output of clothrises; output of food falls.

The response of output to a change in the relative price of cloth:

The economy always produces at the point on itsproduction possibility frontier (PP) where the slopePP equals minus the relative price of cloth.

An increase in Pc (Pc>Pf) causes production tomove down and to the right along the productionpossibility frontier corresponding to higher outputof cloth and lower output of food.

Determination of relative Prices:

Gains from trade: - Without trade, the economy’s output of a good must equal its consumption. - International trade allows the mix of cloth and food consumed to differ from the mix produced. - The country cannot spend more than it earns: PcDc + PfDf = PcQc + PfQf o Can be rearranged: Df – Qf = (Pc/Pf) * (Qc – Dc)  Df – Qf  economy’s food import (the amount at which its consumption of food exceeds its production)  (Pc/Pf) * (Qc – Dc)  product of the relative price of cloth and the amount by which production of cloth exceeds consumption, that is, the economy exports of cloth  Economy imports an amount of food equal to the relative price of cloth times the amount of cloth exported equation known as the budget constraint Income Distribution and the Gains from Trade

Point 2: economies production (economy has to choose itsconsumption along the budget constrain line)Point 1: before trade, economy has to consume what itproducesThe colored section: feasible post trade consumptionchoices, higher than 1

Trade is a source of potential gain for everyone:

• When no trade: consumption = production
• With trade: consume more of both goods
• If the economy as a whole can consume more goods then it is possible to give eachindividual more of both goods: everyone better offo Fundamental reason why better off with trade: expands the country’s economychoices

IV. Political Economy of Trade: A Preliminary View

• International trade shifts the relative price of cloth to food, so factor prices change.
• 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.

1. Trade benefits a country by expanding choices.
   • Possible to redistribute income so that everyone gains from trade.
   • Those who gain from trade could compensate those who lose and still be better off themselves.

• That everyone could gain from trade does not mean that they actually do – redistribution usually hard to implement.

2. Trade often produces losers as well as winners.

• Optimal trade policy must weigh one group’s gain against another’s loss.
• Some groups may need special treatment because they are already relativelypoor (e., shoe and garment workers in the United States).
• Most economists strongly favor free trade.

3. Typically, those who gain from trade are a much less concentrated, informed, andorganized group than those who lose.

• Example: Consumers and producers in the U. sugar industry, respectively

4. Governments usually provide a “safety net” of income support to cushion the losses togroups hurt by trade (or other changes).

 Trade and unemployment

• Trade shifts jobs from import-competing to export sector.

  • Process not instantaneous – some workers will be unemployed as they look for new jobs.

• How much unemployment can be traced back to trade?

  • From 2001 to 2010, only about 2% of involuntary displacements stemmed from import competition or plants moved overseas.

• Figure 4 shows that there no evidence of a positive correlation between unemployment and imports (relative to U. GDP) for the U. - After 2012, both imports and unemployment do drop significantly; However, the drop in imports was driven by falling oil prices. Non-oil imports as a share of U. GDP remained stable in those years.

• Unemployment is primarily a macroeconomic problem that rises during recessions.

  • The best way to reduce unemployment is by adopting macroeconomic policies to help the economy recover, not by adopting trade protection.

Manufacturing employment and Chinese import competition: problematics: - Is import competition from developing countries—especially from China—at fault for declines in manufacturing employment in the United States? - Would closing off the United States from trade with China increase the share of employment in U. manufacturing?

If there are no obstacles, then workers move to foreign until the purchasing power of wages isequal across countries (point A) (what has purchasing power to do with this?) - Emigration from home decreases the supply of labor and raises real wage of the workers who remain there ( workers home earn more due to emigration) - Immigration into foreign increases the supply of labor so real wage decreases thereConsequences: - Workers initially in Home benefit while workers in Foreign are hurt by inflows of other workers. - Landowners in Foreign gain from the inflow of workers decreasing real wages and increasing output. - Landowners in Home are hurt by the outflow of workers increasing real wages and decreasing output.

Example in the US economy: - The largest increase in recent immigration occurred among workers with the lowest education levels, making less educated workers more abundant. - Possibly reduced wages for native-born workers with low education levels while raising wages for the more educated - Widening wage gap between less educated workers and highly educated workers.

VI. Summary

1. International trade often has strong effects on the distribution of income within countries - produces losers as well as winners.
2. Income distribution effects arise for two reasons: a. Factors of production cannot move costlessly and quickly from one industryto another. b. Changes in an economy’s output mix have differential effects on the demandfor different factors of production.
3. International trade affects the distribution of income in the specific factors model. a. Factors specific to export sectors in each country gain from trade, whilefactors specific to import-competing sectors lose. b. Mobile factors that can work in either sector may either gain or lose.
4. 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.
5. Most economists would prefer to address the problem of income distribution directly, rather than by restricting trade.
6. Those hurt by trade are often better organized than those who gain, causing trade restrictions to be adopted.

Labor is a mobile factor: it will move from the low wage sector to the high wage sector untilwages are equalized.

Chapter 5 : Resources and Trade, The Heckscher-Ohlin Model

 Explain how differences in resources generate a specific pattern of trade. Discuss why the gains from trade will not be equally spread even in the long run and identify the likely winners and losers. Understand the possible links between increased trade and rising wage inequality in the developed world. See how empirical patterns of trade and factor prices support some (but not all) of the predictions of the factor-proportions theory.Intro:Trade also occurs due to differences in resources across countries (+ differences in laborproductivity) The Heckscher-Ohlin theory argues that trade occurs due to differences in labor, laborskills, physical capital, capital, or other factors of production across countries

• Countries have different relative abundance of factors of production
• Production processes use factors of production with different relative intensity.

In a society of relative abundance (i., a society in which there is at least “just enough” togo around), it is conceivable that a gift economy would arise, with givings and receivingsflowing freely among all social beings

Intersection of labor and capital constraints occurs at 500 calories of food and 750yards of cloth (point 3).

If capital cannot be substituted for labor or vice versa, the production possibility frontier inthe factor-proportions model would be defined by two resource constraints: The economycan’t use more than the available supply of labor (2,000 work-hours) or capital (3,machine-hours). So the production possibility frontier is defined by the red line in this figure.

The opportunity cost of producing one more yard of cloth, in terms of food, is not constant: - When the economy produces a low amount of cloth and a high amount of food, then the opportunity cost is 2/ - When the economy produces a high amount of cloth and a low amount of food, then the opportunity cost is 2Conclusion: when the economy devotes more resources toward the production of one good,the marginal productivity of those resources tends to be low so that the opportunity cost ishigh

Unit factor requirements are constant along each line segment of the PPF

When producers can substitute one input factor for the other in the production process, thePPF becomes curved (the opportunity cost of cloth increases as producers producers makemore cloth).

The production possibility frontier with factor substitution:

If capital can be substituted for labor and viceversa, the production possibility frontier nolonger has a kink. But it remains true that theopportunity cost of cloth in terms of food risesas the economy’s production mix shifts towardcloth and away from food

The economy produces at the point that maximizes the value of production,V (isovalue)

Isovalue: Isovalue lines represent different budget constraint, V, value of the total production,also the maximum an economy can afford to consume. Isovalue line represents a constantvalue of production.

V =P QC C +P QF F

• P represents the prices of cloth and food

• Slope of isovalue line is -pc/pf (the slope of the isovalue line is relative price of cloth to food, in negative term )

• The tangent point Q is the optimal achievable production combination under certain budget constraint, V, and relative price between cloth to food

• As relative price changes, Q also changes

At point Q, , the relative price of cloth equals the slope of the PPF, which equals theopportunity cost of producing cloth. - The trade-off in production equals the trade-off according to market prices.

II. Changing the mix of inputs

• Producers may choose different amounts of factors of production used to make cloth or food.Their choice depends on the wage, w, paid to labor and the rental rate (The periodic chargeper unit for the use of property), r, paid when renting capital.
• As the wage w increases relative to the rental rate r, producers use less labor and morecapital in the production of both food and clothInput possibilities in food production:

A farmer can produce a calorie of food with less capitalif he or she uses more labor, and vice versa.

If the relative price of cloth rises, the wage-rental ratio must rise. This will cause the labor-capital ratio used in the production of both goods to drop.

 An increase in the relative price of cloth Pc/Pf, is predicted to: - Raise income of workers relative to that of capital owners w/r - Raise the ration of capital to labor to labor sevices,K/L, used in both industries - Raise the real income (purchasing power) of workers and lower the real income of capital owners

Resources and output: How do levels of output change when the economy’s resourceschange? - Rybczynski theorem: If you hold output prices constant as the amount of a factor of production increases, then the supply of the good that uses this factor intensively increases and the supply of the other good decreases.

Example:Assume an economy’s labor force grows, which implies that its ration of labor to capital L/Kincreases - Expansion of production is biases towards cloth - To employ the additional workers, the economy expands production of the relatively labor-intensive good cloth and contracts production of the relatively capital-intensive good food:

An increase in the supply of labor shifts theeconomy’s production possibility frontier

outward disproportionately in the direction of cloth production. At an unchangedrelative price of cloth, food production declines.

• An economy with a high ratio of labor to capital produces a high output of cloth relative to food.
• Suppose that Home is relatively abundant in labor and Foreign in capital:

L LK K

>

• Likewise, Home is relatively scarce in capital and Foreign in labor.
• Home will be relatively efficient at producing cloth because cloth is relatively laborintensive.

IV. Trade in the Heckscher-Ohlin model

• The countries are assumed to have the same technology and the same tastes.
  • With the same technology, each economy has a comparative advantage in producing the good that relatively intensively uses the factors of production in which the country is relatively well endowed.
  • With the same tastes, the two countries will consume cloth to food in the same ratio when faced with the same relative price of cloth under free trade.

Since cloth is relatively labor intensive, at each relative price of cloth to food, Home willproduce a higher ratio of cloth to food than Foreign. - Home will have a larger relative supply of cloth to food than Foreign. - Home’s relative supply curve lies to the right of Foreign’s.

Trade leads to a Convergence of relative prices:

In the absence of trade, Home’s equilibrium would be at point 1, where domestic relativesupply RS intersects the relative demand curve RD. Similarly, Foreign’s equilibrium would beat point 3. Trade leads to a world relative price that lies between the pretrade prices, such as atpoint 2.

• Like the Ricardian model, the Heckscher-Ohlin model predicts a convergence of relative prices with trade.