Lesson 10: Specific-Factors Model (continued)

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1 International trade in the global economy 60 hours II Semester Luca Salvatici Lesson 10: Specific-Factors Model (continued) 1

2 1 Specific-Factors Model The Home Country Opportunity Cost and Prices FIGURE 3-3 Increase in the Relative Price of Manufactures In the absence of international trade, the economy produces and consumes at point A. The relative price of manufactures, P M /P A, is the slope of the line tangent to the PPF and indifference curve U 1, at point A. With international trade, the economy is able to produce at point B and consume at point C. The world relative price of manufactures, (P M /P A ) W, is the slope of the line BC. The rise in utility from U 1 to U 2 is a measure of the gains from trade for the economy.

3 1 Specific-Factors Model The Foreign Country For the sake of focusing on one case, let us assume that the Home no-trade relative price of manufacturing is lower than the Foreign relative price, (P M /P A ) < (P* M /P* A ). This assumption means that Home can produce manufactured goods relatively cheaper than Foreign, or, equivalently, that Home has a comparative advantage in manufacturing. Overall Gains from Trade The good whose relative price goes up (manufacturing, for Home) is exported and the good whose relative price goes down (agriculture, for Home) is imported. By exporting manufactured goods at a higher price and importing food at a lower price, Home is better off than it was in the absence of trade.

4 Specific-Factors Model How does a change in relative prices of goods impact the earnings of workers, landowners and capital owners? We begin from earnings of labour (what happens to the wages when there is an increase in the relative price of manufactures) To determine the impact of international trade on wages in the two sectors, we put the marginal product of labor for agriculture and manufacturing on the same graph

5 Determination of Wages 2 Earnings of Labor FIGURE 3-4 (1 of 2) Allocation of Labor between Manufacturing and Agriculture The amount of labor used in manufacturing is measured from left to right along the horizontal axis, and the amount of labor used in agriculture is measured from right to left.

6 Determination of Wages FIGURE 3-4 (2 of 2) 2 Earnings of Labor Allocation of Labor between Manufacturing and Agriculture (continued) Labor market equilibrium is at point A. At the equilibrium wage of W, manufacturing uses 0 M L units of labor and agriculture uses 0 A L units.

Change in Relative Price of Manufactures FIGURE 3-5 2 Earnings of Labor Increase in the Price of Manufactured Goods With an increase in the price of the manufactured good, the curve P M MPL M shifts

7 Change in Relative Price of Manufactures FIGURE Earnings of Labor Increase in the Price of Manufactured Goods With an increase in the price of the manufactured good, the curve P M MPL M shifts up to P M MPL M and the equilibrium shifts from point A to point B. The amount of labor used in manufacturing rises from 0 M L to 0 M L, and the amount of labor used in agriculture falls from 0 A L to 0 A L. The wage increases from W to W, but this increase is less than the upward shift P M MPL M.

8 2 Earnings of Labor Change in Relative Price of Manufactures Effect on the Wage An increase in the relative price of manufacturing P M /P A can occur due to either an increase in P M or a decrease in P A. Both these price movements will have the same effect on the real wage, that is, on the amount of manufactures and food that a worker can afford to buy.

9 Change in Relative Price of Manufactures FIGURE 3-5 (reproduced) 2 Earnings of Labor Effect on Real Wages Notice that the increase in the wage from W to W is less than the vertical increase ΔP M MPL M that occurred in the P M MPL M curve. When ΔW/W < ΔP M /P M, then the percentage increase in the wage is less than the percentage increase in the price of the manufactured good. This inequality means that the amount of the manufactured good that can be purchased with the wage has fallen, so the real wage in terms of the manufactured good W/PM has decreased.

10 2 Earnings of Labor Change in Relative Price of Manufactures Overall Impact on Labor In the specific-factors model, the increase in the price of the manufactured good has an ambiguous effect on the real wage and therefore an ambiguous effect on the well-being of workers. Although ambiguous, this conclusion is important. The result is different than what was found in the Ricardian model, where labor unambiguously earned a higher real wage. This warns us that one cannot make unqualified statements about the effects of trade on workers. The effect of trade on real wages can be complex.

11 2 Earnings of Labor Change in Relative Price of Manufactures Unemployment in the Specific-Factors Model It is hard to combine business cycle models with international trade models to isolate the effects of trade on workers. Once we recognize that workers can find new jobs possibly in export industries that are expanding then we still cannot conclude that trade is necessarily good or bad for workers. In the two applications that follow, we look at some evidence from the United States on the amount of time it takes to find new jobs and on the wages earned, and at attempts by governments to compensate workers who lose their jobs because of import competition. This type of compensation is called Trade Adjustment Assistance (TAA) in the United States.

APPLICATION Manufacturing and Services in the United States: Employment and Wages across Sectors TABLE 3-1 (2 of 3) Job Losses in Manufacturing and Service Industries, 2005 2009 This table shows the

12 APPLICATION Manufacturing and Services in the United States: Employment and Wages across Sectors TABLE 3-1 (2 of 3) Job Losses in Manufacturing and Service Industries, This table shows the number of displaced (or laid-off) workers in manufacturing and service industries from 2005 to Between 64% and 68% of the workers displaced from 2005 to 2007 were reemployed by January 2008, with about one-half earning less in their new jobs and one-half earning the same or more, with slightly more workers reemployed in service industries earning more at their new job.

APPLICATION Manufacturing and Services in the United States: Employment and Wages across Sectors TABLE 3-1 (3 of 3) Job Losses in Manufacturing and Service Industries, 2005 2009 This table shows the

13 APPLICATION Manufacturing and Services in the United States: Employment and Wages across Sectors TABLE 3-1 (3 of 3) Job Losses in Manufacturing and Service Industries, This table shows the number of displaced (or laid-off) workers in manufacturing and service industries from 2005 to However the recession that began in 2008 clearly increase the number of displaced workers From January 2008 to December 2009 the total number of displaced workers increased to 5.1 million, of which 2.1 million had been employed in manufacturing. n.a. = not available.

14 3 Earnings of Capital and Land Determining the Payments to Capital and Land We then analyse earnings of capital and land (what happens to the rental on capital and land when there is an increase in the relative price of manufactures). If Q M is the output in manufacturing and Q A is the output in agriculture, the revenue earned in each industry is P M Q M and P A Q A, and the payments to capital and to land are: Payments to capital = P M Q M W L M Payments to land = P A Q A W L A

3 Earnings of Capital and Land Determining the Payments to Capital and Land The earnings of one unit of capital (a machine, for instance), which we call R K, and the earnings of an acre

15 3 Earnings of Capital and Land Determining the Payments to Capital and Land The earnings of one unit of capital (a machine, for instance), which we call R K, and the earnings of an acre of land, which we call R T, are calculated as: Economists call R K the rental on capital and R T the rental on land. We can calculate RK and RT also in this way: RK = PM MPKM and RT =PA MPTA

16 3 Earnings of Capital and Land Determining the Payments to Capital and Land Change in the Real Rental on Capital As more labor is used in manufacturing, the marginal product of capital will rise because each machine has more labor to work it. In addition, as labor leaves agriculture, the marginal product of land will fall because each acre of land has fewer laborers to work it. The general conclusion is that an increase in the quantity of labor used in an industry will raise the marginal product of the factor specific to that industry, and a decrease in labor will lower the marginal product of the specific factor.

International Trade: Economics and Policy. LECTURE 6: Absolute vs. Comparative Advantages (continued)

Department of Economics - University of Roma Tre Academic year: 2016-2017 International Trade: Economics and Policy LECTURE 6: Absolute vs. Comparative Advantages (continued) International Trade Equilibrium