CHAPTER 3 SPECIFIC FACTORS AND INCOME DISTRIBUTION

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CHAPTER 3SPECIFIC FACTORS AND INCOME
DISTRIBUTION
by Richard Baldwin, Graduate Institute of
International Studies, Geneva
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C.A. Lessons

• C.A. is about comparative costs of producing
  things
• Main lesson of c.a.
• 1. GFT for all nations due to improved efficiency
  of allocation of national resources
• We can get this even with fixed wage rates, as
  long as w/w is s.t. both nations produce
  something in free trade
• All that matters is that nations have different
  relative costs of producing, thus some trade
  economist use phrase theory the theory of
  comp.cost theory instead of theory of
  comp.adv.
• In words, nations gain by focusing on making
  things they do relatively well (or at least
  things where their disadvantage is least marked)
  AND buying from other nations who are doing the
  same in different goods
• Contest Group with best completion of following
  
• Mr Ambassador, the principle of comparative
  advantage states that
• Assume the Ambassador is particularly well
  connected but not particularly well educated.
• Hand in entries by end of today. Secret ballot
  voting to chose winner tomorrow.

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Ricardian model Lessons

• Main lessons of Ricardian model
• 1. All the c.a. lessons AND
• 2. Model is simple since only one factor of
  production so eqm factor prices easy to
  calculate. (pedagogical rather than realistic,
  i.e. only part of the full picture)
• Blind men the elephant parable
• 3. When eqm factor prices are calculated, we can
  predict the direction of trade using Law of
  C.A.
• nations tend to export goods that they can
  produce relatively cheaply in autarky (very
  abstract, but intuitive explain of trade pattern)
• 4. Division of GFT depends on many things
  tastes, country size, distribution of technology
  differences
• 5. Technological differences are the ultimate
  reason for trade
• EXTRA Free trade allows the market to find each
  nations c.a..
• EXTRA Doctors dysentery parable.

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C.A. trade models

• Different trade models focus on different
  sources of comparative advantage, i.e.
  different reasons for why relative costs would
  vary across countries
• Typically each trade model focuses on only one
  cause
• (you should combine these in your mind doing so
  formally would make things too complex to
  understand)

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C.A. trade models

• Merits of Ricardian model is its simplicity one
  factor of production, so factor prices easy to
  calculate
• Downside Side effect of one factor is that no
  domestic distribution issues arise
• Most of trade policy is about the domestic
  distribution issues, so Ricardian model is not
  very useful beyond illustrating principles of GFT
  due to production efficiency increase
• Ricardo-Viner model adds in more factors
• Well see that although nations gain
• Gains from trade
• There are also winners and losers from trade
• Pains from trade

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Ricardo-Viner a.k.a. Specific Factors

• Basic setup
• 2 goods, 3 factors, two nations
• Perfect competition constant returns to scale
  (CRS)
• One good (manufacturesM)
• Made with capital (K) and labour (L)
• One good (foodF)
• Made with land (Tterre) and labour (L)
• Land is a specific factor (specific to F
  sector)
• Capital is a specific factor (specific to M
  sector)
• Recall the cannonball feather parable

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Preliminary points necy to understand SFM

• Diminishing returns w.r.t. labour
• A key point is that marginal increase in output
  of either sector falls as amount of labour
  applied rises
• e.g. fixed amount of land adding labour raises
  total output, but at a diminishing rate
• Natural outcome since land per worker falls
• 80-20 principle.
• Do examples

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• Plot the MPL for M
• As the amount of labour employed in M sector
  rises, the MPLm falls
• This is plotted directly in right panel (not to
  scale)

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• How much labour hired in M sector?
• Take Pm and w as given
• Step 1 draw VMPLm Pm MPLm
• Step 2 find where wVMPLm

euros
w
VMPLm
Lm
Lmo
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• How do we know this is right?
• Good general approach to learning economics
• Spose a mistake L instead of
• Could increase profits by hiring more labour

euros
Marginal benefit from hiring more labour
Marg. Cost of same
W
w
Lmo
VMPLm
Lm
Lmo
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• Same is true for F sector
• (Why must w be same in both sectors?)
• But how do we know that LfLmL?
• Diagrammatic trick, beaker diagram Fig.3-4
  (very important)

euros
Food
Manufactures
w
VMPLf
Lf
Lfo
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Step 1 Flip F-sector diagram
euros
w
VMPLm
Lm
Lmo
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Step 2 put 2 together
euros
w
VMPLf
Lf
Lfo
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• Step 3 Make sure length of horizontal is equal
  to total labour supply
• - This is the beaker diagram, or
  specific-factors model (SFM) diagram
• It gives the wage if we know the prices of M F,
  
• BUT where do these come from?
• ANSWER (as always)
• Relative Demand (RD) and Relative Supply (RS)
• As in Ricardian model

(10k Hours)
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How to construct RS for SFM

• Well see how relative output of M and F changes
  when the relative price changes

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• If relative price of M rises
• Say Pm ?, but Pf constant
• More labour drawn into M sector, so more M is
  produced and less F
• Relative supply of Qm/QF rises with relative
  prices
• This yields RS

Pm/Pf
RS
2
1
Qm/Qf
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• Putting RS RD together
• (RD just as in Ricardian)
• RD RS gives us relative prices.
• SFM diagram then gives us wage, allocation of
  labour and production (implicit)

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• Next well consider two nations that have
  different endowments, so we need to see how
  changes in endowment will change the RS curve
• This will help us find the Foreign RS when the
  time comes.

• Suppose K supply ?.
• VMPLm ? (higher MPL since more K per worker than
  before)
• In eqm (for same prices), more M is produced and
  less F since L is drawn into M
• Means higher relative supply of M at any given
  relative price, i.e. RS shifts ?

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Free trade in Ricardo-Viner

• NB
• Here RSJ is for K-abundant nation RSA for the
  K-scarce nation (i.e. T-abundant)
• - (Why?)
• Free trade means relative price of M rises in the
  K abundant nation falls in K scarce nation
• This means J tends to specialise in production of
  the K-intensive good A in the T-intensive good

RSworld Avg of Js As RS
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Factor content approach to trade

• One way to think about this model, is to view
  trade in goods as a disguise for trade in
  factors.
• Think about the K, T L embodied in the goods
  imported and exported.
• The relatively K-abundant nation, exports the
  relatively K-intense good imports the
  relatively T-intense good.

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Free trade in Ricardo-Viner

• Consumption effects
• relative price of M rises in nation J means
  consumers demand relatively less M and relative
  more F
• relative price of M falls in nation A, means
  nation-A consumers relative demand changes
  opposite direction.
• Summary
• J produces more M and less F, but its consumers
  increase consumption of F relative to M, THUS J
  exports M and imports F
• A does the opposite A imports M and exports F
• NB law of c.a. holds once again

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GFT

• To see the GFT in each nation, use a different
  diagram (PPF IC).
• This is sometimes called the sacred trade
  diagram since it is used so often to illustrate
  points.
• This diagram shows nation A in autarky.
• Postpone the consideration of GFT until we
  justify this diagram.

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• Deriving the PPF for the SFM
• Start with the RS curve use tangency property
• PPF is bowed due to diminishing returns to labour
  in MF
• As amt of L in M rises, the MPL in M falls while
  MPL in F rises
• This means the amt of F that must be foregone to
  get an extra unit of M rises as the amt of M
  produced rises

Cost of more F i.t.o foregone M production
Pm/Pf
RS
1
Ditto
2
Qm/Qf
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• Autarky (auky) vs Free Trade (FT) for nation J
  (who saw relative price of food fall)

3. Red area shows that nation J has the
possibility of consuming more of F more M -
THUS, GFT for nation as whole are possible.
1.Auky point (consn prodn)
2.FT budget line, national consn can be anywhere
on this line (or below)
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• Simple case of identical consumers so can use one
  IC for everyone in nation J

2.FT consn point
1.Auky point (consn prodn)
2
3.FT prodn point
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• Can see trade pattern in this diagram
• Trade triangle
• NB consumption production move in opposite
  directions in response to relative price change
• Can think of trade like a technological
  improvement
• Cheese/watch factory parable

FT point
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Pains from trade

• Next consider the domestic redistribution of
  income due to the relative price change
• To this end, we need to study additional features
  of the VMPL curve
• As we shall see, this lets us define reward to
  specific factor (Ricardian surplus)

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• Appendix chap 3 goes over this material but does
  it a way that makes it difficult to integrate
  into what weve done.
• Here I show the changes I make to Krugmans
  diagrams
• Put euros on y-axis, no change x-axis.
• Plot VMPL not MPL

euros
VMPLm PmMPLm
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• The area under the VMPL between zero and L is
  value of output of the M sector
• Why?

euros
VMPLm PmMPLm
L
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• The value of output of the M sector is divided
  between K owners and workers
• Payment to workers is the wage times L
• Rest is kept by capital owners (Ricardian
  surplus)
• Similar reasoning gives income of landowners

euros
w
VMPLm
Lm
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Pains from trade (contd)

• Auky to FT raises the relative price of M in
  nation J
• This shifts the VMPLm curve up without changing
  the VMPLf curve (take food as numeraire so Pf1)
• Look at effects on incomes of K, L and T

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• Positive effects
• 1. Pm ? so VMPLm ?
• 2. w ?, less than Pm ?
• 3. Lm ?

euros
Auky VMPLm
FT VMPLm
VMPLf
C
A
w
o
w
Lm (auky)
Lm (FT)
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• Welfare effects
• 1. total payts to L ? by D1D2D3, but Pm ? so
  cant say if real income ?.
• (w i.t.o. F ? but ? i.t.o. M, so ambiguous impact
  on Ls consn).
• 2. Ks income rises by B1-D1
• ? (why?)
• 3. Ts income ? ( i.t.o. both goods, so consn
  ?.

euros
Auky VMPLm
FT VMPLm
VMPLf
B1
C
A
w
D2
D1
D3
o
w
L (auky)
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Pains from trade (contd)

• This is the pains from trade.
• Any change in relative prices will hurt some
  groups in society and help others.
• From our PPF analysis, we know that the winners
  win more than the losers lose, but trade almost
  always creates winners losers.
• Theoretically possible to design transfer system
  to create a Pareto gain from trade (i.e. winners
  compensate losers)
• In rich nations, govts have policies to share
  the benefits of any changes.
• Unemployment insurance, social welfare
  programmes, progressive tax systems, etc.
• Poor nations dont/cant administer such systems,
  so pains of trade may be more of a problem.

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Gains Pains from trade Lessons

• Trade creates potential gains for society proper
  govt policy can ensure a fair distribution of
  income.
• Any change in relative prices regardless of
  source will create gains pains
• Changes in endowments
• Changes in technology
• Changes in tastes
• Change is essential to growth progress
• e.g. Horses replaced by Railroads
• Good governance requires a system to ensure that
  nation as a whole approves of the continual
  stream of change that growth implies
• Trade is just one example
• European, Canadian, Japan, systems of safety
  nets for losers

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Application Political economy of trade

• Losers from lower import prices often lobby to
  impose protection
• e.g. Owners of US clothing industry lose from
  removal of MFA quotas on Chinese imports.
• Winners are US consumers and, via G.E. effects,
  export industries
• Olsens asymmetry
• Often losers from cheaper imports are better
  organised politically than winners,
• Few losers concentrated losses clear cause of
  loss often geographically concentrated easy
  to organise
• Winners numerous gains small per person often
  geographically disperse hard to organise
• ERGO, losers often win the political battle get
  protection from cheap imports.

Mancur Olsens famous book The logic of
collective action, 1965
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Application Political economy of trade

• You can use the beaker diagram to study impact
  of protection, if you take world relative price
  as given and tariff raises the relative price of
  imports
• Just reverse the direction of arrows in auky to
  FT diagram

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• Veitch slides.

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Effect of a Change in Relative Price
Wage Rate, w
Wage Rate, w
PXMPLX
w
PYMPLY
LY
LX
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Growth in Good X Specific Capital
Wage Rate, w
Wage Rate, w
VMPX
w
VMPY
LX
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Growth in Mobile Factor, Labor
Wage Rate, w
VMPX