International Economics I - Class 2-3

Gains From Trade and Redistributive Eects in the

Classical Framework: The Specic Factors Model
Alessandra Bonglioli
Universitat Pompeu Fabra
UPF

Fall 2015

A. Bonglioli

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Class 2-3

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Questions

why do countries trade? because it brings gains:

I
I
I

what is needed for trade to be benecial?

which are the gains from trade
who gains and who loses from trade in each country?

A. Bonglioli

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Class 2-3

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Plan

well answer within the framework of the classical model with specic
factors:
I
I

2 goods: manufactures, M, and agricultural goods, A

3 factors of production:
F
F
F

I
I
I

labor, L, used to produce A and M (L mobile between sectors)

land, T , used to produce A (T specic factor)
capital, K , used to produce M (K specic factor)

technology with decreasing marginal productivity of factors

convex preferences
perfect competition + full employment

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Preview of the Answers

what is needed for trade to be benecial?
I

diverse trading partners ! dierent relative price of goods

which are the gains from trade?

I

every country expands its choice set

why opening to trade?

I

rms specialize in the good that becomes relatively more expensive

F

income" ! consumers can demand more of both goods (gains from

specialization)

consumers can demand dierent quantities from the produced ones

(gains from exchange)

who wins and who loses from trade in each country?

I
I
I

winner: specic factor of the good that becomes relatively more

expensive
loser: specic factor of the good that becomes relatively cheaper
uncertain: mobile factor

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Class 2-3

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Production: Technology
production function of manufactures
QM = QM (K , LM )
I
I
I

QM = quantity of M produced
LM = labor employed in manufactures
K = capital

production function of agricultural goods

QA = QA (T , LA )
I
I
I

QA = quantity of A produced
LA = labor employed in agriculture
T = land

decreasing marginal productivity of labor, MgPLM and MgPLA :

I

every additional worker produces less than the previous ones

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Production: Technology

QM

MgPLM

QM =QM (K, LM)

MgPLM

LM

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Class 2-3

LM

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Production Possibility Frontier (PPF)

how much of each good can the economy produce?
labor endowment = L
in equilibrium, L is allocated between the production of M and A
LM + LA = L
for given labor allocation, L1M , L1A , the economy produces
I
I

1 =Q
1
QM
M K , LM of manufactures
QA1 = QA T , L1A of agricultural goods

if we move 1 worker from A to M:

I
I

2 and Q 2 change?
how do quantities QM
A
the PPF curve tells us

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Class 2-3

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Production Possibility Frontier (PPF)

QM

QA
Q1 A
Q2 A

Q2 M
Q1 M

L1M L1M+1

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LM

Class 2-3

L1A-1 L1A

LA

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Production Possibility Frontier (PPF)

QA
Q1A
Q2A

PPF

Q1M
A. Bonglioli

(UPF)

Q2M
Class 2-3

QM
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PPF: Explanation and Analytical Expression

1
assume QA1 >> QM
I
I
I

given decreasing returns, QM increases more than QA falls

since the abundance of A relative to M implies a low opportunity cost
of increasing the production of M
this is why the PPF is concave

analytically, shifting one hour of work from A to M:

I
I
I

increases the production of M by a quantity equal to the marginal

productivity of labor, MgPLM
reduces the production of A by a quantity equal to the marginal
productivity of labor, MgPLA
the opportunity cost of M relative to A is equal to the slope of the
PPF:
MgPLA
MgPLM

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Class 2-3

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Relative Supply: Optimal Production

in perfect competition, rms:
I
I

take goods and factors prices as given

decide how much to produce to maximize prot
max i = Pi Qi (Li , F )
Li

wi Li for i = M, A and F = K , T

optimality condition: marginal cost of labor equals its marginal product

F

note: marginal product=price*marginal productivity!

wM
wA

A. Bonglioli

=
=

PM

MgPLM

PA

MgPLA

note: the owner of the specic factors earns MgPLi

worker up to the last one hired

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wi /Pi on each

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Relative Supply: Equilibrium Production

wages must be equal in both sectors since labor is mobile between M

and A
wM = wA = w
equilibrium production of M and A:
I

lies at the tangency between the PPF and the line of the relative price
of M:
PM
MgPLA
=
MgPLM
PA
i.e., opportunity cost of M = relative price of M
given technology and factor endowment, what determines production is
the relative price

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Class 2-3

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Relative Supply: Equilibrium Production

0 > P ):
if the price of M increases (PM
M
I
I
I

rms want to employ more labor in M ! wM "

as L moves from A to M, MgPLA " and MgPLM # ! wA " and wM #
the reallocation of L goes on until wM = wA = w and
0 /P
MgPLA /MgPLM = PM
A

overall:
I
I

relative supply (RS) is increasing in the relative price

(PM /PA "! QM /QA ")
w increases less than PM since MgPLM /MgPLA # due to reallocation
of L
F

A. Bonglioli

note: this is due to the fact that the other factor is specic and can be
interpreted as a short-run eect (well see that w varies by more if all
factors are mobile)

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Relative Demand: Optimal Consumption

demand of the quantities of M and A maximizes utility subject to the

budget constaint
utility function
U = U (DM , DA )
I
I
I

increasing in the quantities consumed of M and A, DM and DA

positive and decreasing marginal utilities (MgUDA and MgUDM )
described by convex indierence curves in the space of (DM , DA )
F
F

A. Bonglioli

as we prefer consuming a bit of both goods rather than a lot of one

and a little of the other
the opportunity cost of increasing M reducing A is the marginal rate of
substitution, (MgUDM ) / (MgUDA )

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Relative Demand: Optimal Consumption

budget constraint
PM D M + PA D A
I
I

V = disposable income (= value of production)

the budget constraint line has slope PM /PA :
DA =

V
PA

PM
D
PA M

optimal demand of M and A

I

lies where the opportunity cost of M equals its relative price

MgUDM
=
MgUDA

PM
PA

i.e., indierence curve tangent to the line of the relative price of M

RD is decreasing in the relative price

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Class 2-3

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Equilibrium in the Closed Economy

in equilibrium, a closed economy must consume all the quantities
produced
DM = QM and DA = QA
this is possible only if the PPF and the indierence curve are tangent
to the relative price line in the same point
note: in closed economy, two conditions must hold:
I

produced value equals consumed value

V = PM QM + PA QA = PM DM + PA DA

produced quantities equal consumed quatities of each good

DM = QM and DA = QA

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Class 2-3

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Equilibrium in the Closed Economy

QA

E
QEA
UE

pE=-PEM/PEA
QEM

A. Bonglioli

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QM
Class 2-3

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Equilibrium in the Open Economy

good prices are determined in the international market

I

I and P I make international demand equal international supply

PM
A

in open economy, a country can consume dierent quantities from the

produced ones
DM S QM and DA S QA
the only condition that must hold is that produced value equals
consumed value
I
I
V = PM
QM + PAI QA = PM
DM + PAI DA

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Class 2-3

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Equilibrium in the Open Economy

given international prices
I

rms choose the equilibrium production (PPF tangent to the relative

price line)

given international prices and the value of production (i.e., income)

I

consumers choose equilibrium demand (indierence curve tangent to

the relative price line)

if the international relative price is dierent from the closed economy,

production and demand are not equal
I
PM
P
6= M =) DM 6= QM and DA 6= QA
I
PA
PA
I

there is international trade!

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Class 2-3

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Equilibrium in Closed and Open Economy

QA,DA

DIA

QEA

QIA

UI
UE

Q
pE
pI
DIM

A. Bonglioli

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QEM QIM
Class 2-3

QM,DM
Fall 2015

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Gains From Trade (GFT)

I /P I > P /P ):
if the international relative price of M is higher (PM
M
A
A
I

gains from exchange: assuming no change in RS, consumers prefer to

import A and export M
ex
DM
/DAex < QM /QA
F

since they can aord both free-trade and autarky allocations

I D ex + P I D ex =P I D + P I D ), it must by that
(PM
M
A A
M M
A A
ex
U ex (DM
, DAex ) > U E (DM , DA )

gains from specialization: rms optimally increase RS

I
QM
> QM and QAI < QA
F

at international prices, the value of production is higher under the

free-trade allocation:
I
I
I
PM
QM
+ PAI QAI > PM
QM + PAI QA

hence, consumers are richer and can consume more of both goods
I
U I DM
, DAI

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ex
> U ex (DM
, DAex )
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The Gains From Trade (GFT): Graphical Decomposition

QA,DA

DIA

Dex

QEA

QIA

UE

DIM
A. Bonglioli

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QEM QIM
Class 2-3

pI

pI

UI
Uex

pE
QM,DM
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Comparative Advantage and Pattern of Trade

there is comparative advantage in the production of a good (e.g.,
M) if its relative price in closed economy is lower than in open
economy
I
PM
P
> M
I
PA
PA
pattern of trade:
I

a country exports its good of comparative advantage (e.g., M)

I
XM = QM

I
DM
>0

a country exports its good of comparative disadvantage (e.g., A)

MA = DAI

QAI > 0

if trading partners are equal,

I
I
I

their relative prices in open and closed economy coincide

there is no comparative advantage of any country
there are no gains from trade

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Class 2-3

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Comparative Advantage and Absolute Advantage

there is absolute advantage in the production of a good (e.g., M) if
its price in closed economy is lower than in open economy
I

I > P and
a country with absolute advantage in both goods (PM
M
I
PA > PA ) may have comparative advantage in only one
I < P and
a country with absolute disadvantage in both goods (PM
M
I
PA < PA ) may have comparative advantage in only one

trade requires CA, not necessarily AA

there is comparative advantage if countries are dierent
I

well study 2 trade models where comparative advantage arises from:

F
F

A. Bonglioli

dierent technologies across countries: Ricardian model

dierent relative factor endowment across countries: Heckscher-Ohlin
model

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Gains From Trade and Terms of Trade

assume we export M and import A

I

I /P I )
terms of trade = relative price of export (PM
A

what if our terms of trade deteriorate?

I
I
I
I

we produce less M and more A

the value of our production drops
we partly stop exporting M and importing A
our welfare drops

in general:
I
I

if the terms of trade deteriorate (improve), welfare falls (rises)

note: no fall in the t-o-t is able to push U below autarky level!

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Gains From Trade and Terms of Trade

QA,DA

DIA

DIA
QIA

UI
UI

QIA

Q
pI
pI
DIM DIM QIM QIM

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Class 2-3

QM,DM
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Gains From Trade: Summary and Doubts

there are GFT so long as:

I
I
I

countries are dierent

the PPF is concave (no increasing returns)
markets are perfectly competitive

what if one condition fails?

I

well prove that also in case of increasing returns and monopolistic

competitions there are GFT, although of a dierent type

is trade benecial for everybody within a country?

I

how does trade aect dierent factors of production?

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Class 2-3

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The Redistributive Eects of Trade

we take as a measure of welfare real income in terms of both goods

I
consider workers rst: w I /PAI and w I /PM
I

from prot maximization:

wI
wI
= MgPLM and I = MgPLA
I
PM
PA

I /P I " ! Q I /Q I " ! LI " LI # ! w I /P I # w I /P I "

if PM
A
M
A
M
A
M
A

workers gain in terms of A and lose in terms of M

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Class 2-3

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The Redistributive Eects of Trade

consider capitalists: income r is prot from M
I

real income
r
= QM
PM
F

w
r
P
r
L and
= M
PM M
PA
PA PM

PM /PA " ! QM " ! LM " ! w /PM # ! net eect on r /PM ?

from prot maximization:

I

capitalists benet from each additional worker up to the marginal (last)

one (MgPLM (L) > w /PM for L < LM )

capitalists employ more workers (LM ") + pay them less in real terms
(w /PM #)
I net eect: r /P
M "
I
I
I
I r /P = P /P I
A
M
A r /PM "" since also PM /PA "
capitalists gain with respect to both goods
landowners lose with respect to both goods
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Class 2-3

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The Redistributive Eects of Trade: Graph

MgPLM

(w/P M )1

increased r/P M

(w/P M )2

MgPLM

L1M
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LM

L2M
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The Redistributive Eects and Welfare

in the model with specic factors:

I
I

the factor specic of the exporting sector gains

the factor specic of the import-competing sector loses

does it mean that trade is detrimental?

NO: there always exists a policy that can redistribute gains and losses
so that everybody benets from trade
I
I

why?
because trade makes the pie bigger!

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Class 2-3

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Generalization: Mobile Factors

suppose there are 2 factors instead of 3:
I
I
I
I

labor, L, and capital, K

employed in both sectors
mobile between sectors
immobile between countries (no migration, no capital ows)

the PPF remains concave provided that

I

production functions are dierent

QM ( K , L ) 6 = QA ( K , L )

same gains from trade

dierent redistributive eects (well see them later on)
I
I

the model with specic factors captures the short-run eects

the model with mobile factors captures the long-run eects

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Class 2-3

Fall 2015

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