Specific Factors Model

Chapter 3
Specific Factors and Income Distribution Chapter Organization

§ 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
Prepared by Iordanis Petsas
To Accompany
International Economics: Theory and Policy,
Policy Sixth Edition
by Paul R. Krugman and Maurice Obstfeld Copyright © 2003 Pearson Education, Inc. Slide 3- 2
Introduction The Specific Factors Model

§ Trade has substantial effects on the income § Assumptions of the Model
distribution within each trading nation. • Assume that we are dealing with one economy that can produce
two goods, manufactures and food.
§ There are two main reasons why international trade • There are three factors of production; labor (L), capital (K) and
has strong effects on the distribution of income: land ( T for terrain).
• Resources cannot move immediately or costlessly • Manufactures are produced using capital and labor (but not
from one industry to another. land).
• Industries differ in the factors of production they • Food is produced using land and labor (but not capital).
demand. – Labor is therefore a mobile factor that can be used in either
sector.
§ The specific factors model allows trade to affect – Land and capital are both specific factors that can be used
income distribution. only in the production of one good.
• Perfect Competition prevails in all markets.
Copyright © 2003 Pearson Education, Inc. Slide 3- 3 Copyright © 2003 Pearson Education, Inc. Slide 3- 4
The Specific Factors Model The Specific Factors Model

• How much of each good does the economy produce? • The production function for manufactures is given by
– The economy’s output of manufactures depends on how QM = Q M (K, L M) (3-1)
much capital and labor are used in that sector. where:
• This relationship is summarized by a production – Q M is the economy’s output of manufactures
function. – K is the economy’s capital stock
– LM is the labor force employed in manufactures
• The production function for good X gives the maximum
quantities of good X that a firm can produce with • The production function for food is given by
various amounts of factor inputs. Q F = QF (T, LF) (3-2)
– For instance, the production function for manufactures where:
(food) tells us the quantity of manufactures (food) that can – Q F is the economy’s output of food
be produced given any input of labor and capital (land). – T is the economy’s supply of land
– LF is the labor force employed in food
1
• The full employment of labor condition requires that § Production Possibilities
the economy-wide supply of labor must equal the labor
employed in food plus the labor employed in • To analyze the economy’s production possibilities, we
manufactures: need only to ask how the economy’s mix of output
changes as labor is shifted from one sector to the other.
LM + LF = L (3-3)
• Figure 3-1 illustrates the production function for
manufactures.
• We can use these equations and derive the production
possibilities frontier of the economy.

Figure 3-1: The Production Function for Manufactures
• The shape of the production function reflects the law of
Output, QM diminishing marginal returns .
QM = Q M (K , L M) – 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
Labor input, LM of labor.

Figure 3-2: The Marginal Product of Labor Figure 3-3: The Production Possibility Frontier in the Specific Factors Model
Output of food,
Marginal product QF (increasing á)
á Economy’s production
Production function
of labor, MPLM for food possibility frontier ( PP)
1'
QF =QF(K , L F) Q2 F 2'
3'
Labor input in L L2 F Q2 M Output of

PP manufactures, QM
food, LF
(increasing ß)
ß (increasing à)
à
1 L2 M
2
MPLM 3 L Production function
Economy’s allocation AA for manufactures
of labor ( AA)
Labor input, LM Labor input QM =QM(K, LM)
in manufactures,
Copyright © 2003 Pearson Education, Inc. Slide 3- 11 Copyright © 2003 Pearson Education, Inc. LM (increasing â)
â Slide 3- 12
2
§ Prices, Wages, and Labor Allocation • The demand curve for labor in the manufacturing
• How much labor will be employed in each sector? sector can be written:
– To answer the above question we need to look at supply MPL M x PM = w (3-4)
and demand in the labor market. – The wage equals the value of the marginal product of
labor in manufacturing.
• Demand for labor:
– In each sector, profit-maximizing employers will • The demand curve for labor in the food sector can be
demand labor up to the point where the value produced
by an additional person-hour equals the cost of written:
employing that hour. MPL F x PF = w (3-5)
– The wage rate equals the value of the marginal
product of labor in food.

Figure 3-4: The Allocation of Labor
§ The wage rate must be the same in both sectors,

Wage rate, W
Wage rate, W
because of the assumption that labor is freely

P F X MPLF
mobile between sectors. (Demand curve
1 for labor in food)
W1
§ The wage rate is determined by the requirement P M X MPLM
that total labor demand equal total labor supply: (Demand curve for labor in
manufacturing)
Labor used in Labor used

LM + LF = L (3-6) manufactures, LM in food, LF
L1 M L1 F
Total labor supply, L

Figure 3-5: Production in the Specific Factors Model
§ At the production point the production possibility Output of food, QF
frontier must be tangent to a line whose slope is
minus the price of manufactures divided by that of
Slope = -( P M /PF)1
food.
§ Relationship between relative prices and output: Q1 F

1
-MPLF /MPL M = -PM/PF (3-7)

PP
Q1 M Output of manufactures, QM
3
Figure 3-6: An Equal Proportional Increase in the Prices of Manufactures and Food
• What happens to the allocation of labor and the P F 2 X MPL F
distribution of income when the prices of food and P M 2 X MPL M
Wage rate, W
Wage rate, W
manufactures change? P M 1 X MPL M
PM
increases PF increases
2
10%
W2 10%
• Two cases: 10% P F 1 X MPL F
– An equal proportional change in prices wage
increase
– A change in relative prices W1 1

manufactures, LM in food, LF

• When both prices change in the same proportion, no • When only P M rises, labor shifts from the food sector
real changes occur. to the manufacturing sector and the output of
– The wage rate ( w) rises in the same proportion as the manufactures rises while that of food falls.
prices, so real wages (i.e. the ratios of the wage rate to
the prices of goods) are unaffected.
• The wage rate (w) does not rise as much as PM since
– The real incomes of capital owners and landowners also
manufacturing employment increases and thus the
remain the same.
marginal product of labor in that sector falls.

Figure 3-7: A Rise in the Price of Manufactures Figure 3-8: The Response of Output to a Change in the
Wage rate, W Relative Price of Manufactures
7% Wage rate, W Output of food, QF
upward P F 1 X MPL F
Slope = - ( PM /P F)1
shift in
labor
demand
2
Wage W2
rate Q1 F
1 P M 2 X MPL M
rises by W 1 1
less than
7% 1X Q2 F
PM MPL M 2
Slope = - ( PM /P F) 2

Amount of labor PP
manufactures, LM in food, LF
shifted from food Q1M Q2M Output of
to manufactures manufactures, QM
4
Figure 3-9: Determination of Relative Prices
Relative price § Relative Prices and the Distribution of Income
of manufactures, PM /P F RS
• 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?
1
(P M /P F )1 – Workers
– Owners of capital
RD
– Owners of land
Relative quantity
(Q M /QF ) 1
of manufactures, QM/QF
International Trade
The Specific Factors Model in the Specific Factors Model
• Workers: § Assumptions of the model
– We cannot say whether workers are better or worse off;
this depends on the relative importance of manufactures
• Assume that both countries (Japan and America) have
and food in workers’ consumption. the same relative demand curve.
• Therefore, the only source of international trade is the
differences in relative supply. The relative supply might
• Owners of capital:
differ because the countries could differ in:
– They are definitely better off.
– Technology
– Factors of production (capital, land, labor)
• Landowners:
– They are definitely worse off.
International Trade International Trade

in the Specific Factors Model in the Specific Factors Model
Figure 3-10 : Changing the Capital Stock
§ Resources and Relative Supply Wage rate, W Increase
in capital P F 1 X MPL F Wage rate, W
• What are the effects of an increase in the supply of stock, K
capital stock on the outputs of manufactures and food?
– A country with a lot of capital and not much land will
2
tend to produce a high ratio of manufactures to food at W2
any given prices. 1
P M X MPLM2
W1
P M X MPLM1

manufactures, LM Amount of labor in food, LF
shifted from food to
Copyright © 2003 Pearson Education, Inc. Slide 3- 29 Copyright © 2003 Pearson Education, Inc. manufactures Slide 3- 30
5
• An increase in the supply of capital would shift the § Trade and Relative Prices
relative supply curve to the right. • Suppose that Japan has more capital per worker than
America, while America has more land per worker
than Japan.
• An increase in the supply of land would shift the – As a result, the pretrade relative price of manufactures
relative supply curve to the left. in Japan is lower than the pretrade relative price in
America.
• What about the effect of an increase in the labor force?
– The effect on relative output is ambiguous, although • International trade leads to a convergence of relative
both outputs increase. prices.

Figure 3-11 : Trade and Relative Prices
Relative price of
§ The Pattern of Trade
manufactures, P M /PF • In a country that cannot trade, the output of a good
RSA
must equal its consumption.
RSWORLD
(P M /PF )A
• International trade makes it possible for the mix of
RSJ
manufactures and food consumed to differ from the
(P M /PF )W mix produced.
(P M /PF )J
RDWORLD
• A country cannot spend more than it earns.
Relative quantity of
manufactures, QM/Q F

Figure 3-12 : The Budget Constraint for a Trading Economy Figure 3-13 : Trading Equilibrium
Consumption of food, DF Quantity of Quantity of
Output of food, QF food food
Japanese budget constraint American budget constraint

Budget constraint
(slope = -P M/PF)
America’s QA
F
food
A
Japan’s DJ exports D F
F
1 food
Q1 F
imports QJ F
DJ M QJ M Quantity of QA M DAM Quantity of

Production possibility curve manufactures manufactures
Japan’s America’s
Q1 M Consumption of manufactures, DM manufactures manufactures
Output of manufactures, QM exports imports
6
Income Distribution and Income Distribution and
the Gains from Trade the Gains from Trade
§ To assess the effects of trade on particular groups, the § Could those who gain from trade compensate those
key point is that international trade shifts the relative who lose, and still be better off themselves?
price of manufactures and food. • If so, then trade is potentially a source of gain to
everyone.
§ Trade benefits the factor that is specific to the export

§ The fundamental reason why trade potentially
sector of each country, but hurts the factor that is benefits a country is that it expands the economy’s
specific to the import-competing sectors. choices.
• This expansion of choice means that it is always
§ Trade has ambiguous effects on mobile factors. possible to redistribute income in such a way that
everyone gains from trade.
Income Distribution and The Political Economy of Trade:

the Gains from Trade A Preliminary View
Figure 3-14 : Trade Expands the Economy’s Consumption Possibilities
§ Trade often produces losers as well as winners.
Consumption of food, DF
Output of food, QF § 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
2
already relatively poor (e.g., shoe and garment workers
1
Q 1
F
in the United States).
Budget constraint
(slope = - P M/P F)
– Most economists remain strongly in favor of more or
less free trade.
PP
• Any realistic understanding of how trade policy is
determined must look at the actual motivations of
Q
1 Consumption of manufactures, DM
M
Output of manufactures, QM
policy.
The Political Economy of Trade:

A Preliminary View Summary
§ Income Distribution and Trade Politics § International trade often has strong effects on the
• Those who gain from trade are a much less distribution of income within countries, so that it
concentrated, informed, and organized group than often produces losers as well as winners.
those who lose.
– Example : Consumers and producers in the U.S. sugar § Income distribution effects arise for two reasons:
industry
• 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.
7
Summary Summary
§ A useful model of income distribution effects of § Trade nonetheless produces overall gains in the sense
international trade is the specific-factors model. that those who gain could in principle compensate
• In this model, differences in resources can cause those who lose while still remaining better off than
countries to have different relative supply curves, and before.
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.
Appendix: Appendix:
Further Details on Specific Factors Further Details on Specific Factors
Figure 3A-1: Showing that Output Is Equal to the Area Under the Figure 3A-2: The Distribution of Income Within
Marginal Product Curve the Manufacturing Sector
Marginal Product of Marginal Product of
Labor, MPLM Labor, MPLM
Income of
capitalists
w/PM
Wages
MPLM MPLM
dL M Labor input, LM Labor input, LM

Appendix: Appendix:
Further Details on Specific Factors Further Details on Specific Factors
Figure 3A-3: A Rise in P M Benefits the Owners of Capital Figure 3A-4: A Rise in P M Hurts Landowners
Marginal Product of Marginal Product of
Labor, MPLM Labor, MPLF
Increase in Decline in landowners’

capitalists’ income income
(w/PM) 1 (w/PF) 2
(w/PM) 2 (w/PF) 1
MPLM MPLF
Labor input, LM Labor input, LF


Specific Factors Model

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Chapter 3

Specific Factors and Income Distribution Chapter Organization

Introduction The Specific Factors Model

The Specific Factors Model The Specific Factors Model

The Specific Factors Model The Specific Factors Model

• Figure 3-2 shows the marginal product of labor, which

The Specific Factors Model The Specific Factors Model

Labor input in L L2 F Q2 M Output of

The Specific Factors Model The Specific Factors Model

§ The wage rate must be the same in both sectors,

because of the assumption that labor is freely

Labor used in Labor used

The Specific Factors Model The Specific Factors Model

§ Relationship between relative prices and output: Q1 F

-MPLF /MPL M = -PM/PF (3-7)

Labor used in Labor used

The Specific Factors Model The Specific Factors Model

The Specific Factors Model The Specific Factors Model

Labor used in Labor used

• What is the economic effect of this price increase on

International Trade International Trade

Labor used in Labor used

International Trade International Trade

International Trade International Trade

Japanese budget constraint American budget constraint

DJ M QJ M Quantity of QA M DAM Quantity of

§ Trade benefits the factor that is specific to the export

Income Distribution and The Political Economy of Trade:

The Political Economy of Trade:

dL M Labor input, LM Labor input, LM

Increase in Decline in landowners’

Labor input, LM Labor input, LF

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