CHAPTER 4 – Specific Factor and Income Distribution

Trade: shifting labour from one industry to another due to specialization

In the Ricardian model, not only all countries gain from trade, but also every individual is better off
because of international trade – because in this model trade does not affect income distribution.
Why? In the Ricardian model labour can move freely and it is the only factor of production.

In the real world. Trade has substantial effects on income distribution within each trading country,
so that in practice the benefits of trade are distributed unevenly.
Trade affects distribution income because (1) labour is not free, and (2) factors of production
demanded by different industries differ (not only labour).
(1) Resources cannot move immediately or costless from one industry to another – short run
consequence of trade
(2) Industries differ in the factor of production they demand – long run consequence of trade

While trade may benefit the country as a whole, it often hurts significant groups within the
country in the short-run, and potentially, but to a lesser extent, in the long run

SPECIFIC FACTOR MODEL

Assumptions

- Two goods - cloths and food

- Three factors of production: labour (L), capital (K), and land (T) – labour is a movable
factor because it can be moved from industry to industry – instead, capital and land are
specific factors, they cannot be interchanged between industries (each can be used in
the production of only one good).
- Cloth is produced using K and L (not T)
- Food is produced using T and L (not K)
Imagine workers that have to decide whether to work

How much of each good (cloths and food) does the economy produce?
- This depends on the number of factors of production used in each sector
- To know how much of cloths the economy produce give a certain utilization of K and L
we need the production function of cloths. This function shows the quantity of clothes
that can be produced for any level of K and L.
Q = Q (K, L )
C C C
– Q is the output of cloth
C
– K is the capital stock
– L is the labor force employed in cloth
C
- The production function for food gives the quantity of food that can be produced given
any input of L and T
Q = Q (T, L )
F F F
– Q is the output of food
F
– T is the supply of land
– L is the labor force employed in food
F
Production Possibilities Frontier: how does the economy’s mix of output (clothes and food)
change as labor is shifted from one sector to another?
Underlying assumption – when labor moves from food to clothes, food production falls and cloths’
rise.

Process to get to the PPF

Production function of cloths

The figure shows the relationship between output of clothes and labour force.
The larger labour employed, the higher the output, keeping in mind that K is constant (it does not
vary with changes in labour).

The shape of the function reflects the law of diminishing

marginal returns

Reasoning: Adding one worker to the production process

without increasing the amount of K, means that each
worker has less capital/land to work with (less specific
factor).
Therefore, each additional person-hour adds less output
that the previous.

This means that marginal product of labour declines as more labour is used [marginal product of
labour is the increase in output that corresponds to an
extra unit of labour]

The higher the number of labours employed, the flatten

is getting the shape of the production function.

Recap: the production function of “i” is upward sloping

because as labour employs increase, output increases.
However, the line flattens the more labour is employed.
This because as labour is added, the marginal
productivity of labour decreases. This means that as
labour increases, the impact that the additional person-
hour has on output of “i” lessen.

All this reasoning holds both for cloths and food

For the economy as a whole, the total labor employed in cloth and food must equal the total labor
supply:

L +L =L
C F
The above-mentioned diagrams/functions can be combined to derive the PPF.

How to build PPF

In the lower-right quadrant is

represented the production function of
cloth (flipped)
A movement downward along the vertical
axis (Lc), causes an increase in output of
cloths in the horizontal axis. Displaying
the positive relationship between labour
employed and output of cloths.

In the upper-left quadrant is shown the

corresponding production function for food.
It follows the same reasoning.

N.B. as labour employed in cloths increases,

quantity increases. This movement causes a
corresponding movement in food, causing
labour in food to diminish, thus quantity.

In the lower-left quadrant it is shown the

economy’s allocation of labour, so the
allocation of labour between the two sectors.
[the allocation of labour between the two
sector is determined by the two production
functions].
The downward slope display that an increase
in labour of one sector (thus, increase in
quantity) causes the decrease of labour in
the other sector.
For one person added to clothes, one person is gone for food.

Up to this point we have the elements to determine Qc and Qf given labour employed in the two
sectors, by simply looking at the production functions for cloths and food.
By obtaining the coordinates (Qc, Qf) we can plot them to establish a feasible point in the PPF (a
point that lies in the line)

To trace the whole PPF, we simply imagine repeating this exercise for any possible allocation of
labour AA.

Why is the PPF curved in the Specific Factor Model while in the Ricardian Model was a straight
line?
The curvature of PPF is caused by the law of diminishing returns of labour, this because
diminished returns cause the opportunity cost to rise when an economy increases the production
of one of the two goods.
- For example, if cloths production increases (increase in labour), the opportunity cost of
cloths in terms of food increases (that’s why as we increase cloths, the PPF becomes
steeper)

If we shift one person from food sector to cloths sector, the extra input of labour would increase
the output of cloths by the marginal product of labour – MPLc.
How to increase cloths by 1 unit,
increase labour by 1/MPLc hours
Meanwhile, the unit of labour shifted from the food sector (=the decrease in labour employed)
would decrease food’s output by the marginal product of labour MPLf
To increase output of clothes by one unit, the economy must reduce output of food by
MPLf/MPLc units.

The opportunity cost of cloths in terms of food is (- MPLf/MPLc)

As more units of labour are moved from food sector, each additional person-hour in the cloths
sector become less valuable (productive) than in the food sector.
The marginal product of labour MPLf in food rises and MPLc falls – Opportunity cost of capital of
cloths in terms of food rises.

PRICES, WAGES, and LABOR ALLOCATION

How much labour is employed in each sector?

- We need to analyse the supply and demand in the labour market

Demand for labour

Employers will demand labour up to the point where the value produced by an additional
person-hour equals the cost of employing that hour.
In the cloths sector, for example, the value of an additional person-hour is the MPLc multiplied by
the price of one unit of cloth. The point in which this multiplication equals w, is where employers
stop hiring workers

MPL x P = w ----- this also represents the demand curve for labor in the cloths sector
C C
MPL x P = w ----- this also represents the demand curve for labor in the food sector
F F

Wages across sectors are identical

This figure represents labour demand in the two

sectors
The wage rate must be the same in both sectors
because of the assumption that labour van move
between sectors.

The wage (y-axis) is determined by the

interception between the two demand curves
(Pc*MPLc=Pf*MPLf)

This in turn would determine the equilibrium

allocation of labour in the two sectors (x-axis)
Therefore, labour is allocated so the value of its marginal product is the same in both sectors.
The equilibrium wage and allocation of labour is determined by Pc and Pf.
In this optimal equilibrium (1): at w1 , the sum of Lc and Lf equals the total labour supply L.
A useful relationship between relative prices and output emerges from this analysis of labour
allocation.
MPLc*Pc=MPLf*Pf=w
Rearranging
-MPLf/MPLc= -Pc/Pf
This result also tells us that at the production point, the production possibility frontier must be
tangent to a line whose slope minus the price of cloth divided by that of food.

the economy produces at the point on its PPF where the slope of that frontier equals the relative
price of cloth.

What happens to the allocation of labor and the distribution of income when the prices of food
and cloth change?
1) An equal proportion change in price
2) A change in relative prices

(1) Equal proportion change in price – no real changes

Suppose that both Pc and Pf rise by 10%, the labor demand curve would automatically shift
upward by 10% - (y-axis changes, x-axis not).
These shifts cause an increase by 10% also in wage.
However, the allocation of labor (point of intercept on the x-axis) does not change.

When Pc and Pf change in the same

proportion, no real changes occur. The wage
rate rises in the same proportion as prices, so
real wages rates – the ratios of wage to price
– are unaffected.

With the same amount of labor employed in

each sector, receiving the same real wage
 rate, the real incomes of capital owners and landowners also remain the same. So,
everyone is in the exact same position as before.
[pure inflation]

(2) Suppose only Pc rises by 7%. The increase in Pc shifts the cloth labour demand curve in the
same proportion as price increase (7%). This causes a shift in the equilibrium from point 1
to point 2.

Other consequences:
- Due to the increase in Pc, labour shifts from the food sector to the cloth sector, and the
output of clothes rises while the one of food falls (downward sloping production
functions). Because cloth employment rises, MPLc falls (MPLf rises).
- This causes wage rates to increase, but less than the increase in Pc of 7%. [figure 1]

The cloth labor demand

curve rises in
proportion to the 7%
increase, but wage rate
rises less than 7%.
Labor mover from the
food sector to the cloth
sector. Output of cloth
rises, output of food
falls.
 Response of output change in the
relative price of cloth:
The economy always produces at the
point in PPF where the slope
(opportunity cost) equals the relative
price of cloths. Thus, an increase in
Pc/Pf causes to move down and to
the right along the production
possibility frontier corresponding to
higher output for cloth and lower for
food.

Determination of relative prices

Relative Prices and the Distribution Income

Before turning into the effects of international trade, we must consider the effect of changes in
relative prices on the distribution of income
Example:
Suppose only Pc increases by 10%. Then wage would increase by less than 10%
What is the economic effect of this unequal price increase on the incomes of the following three
groups?

- Workers: we cannot claim whether they are better off or not. This because it depends
on the relative importance of cloth and food in workers’ consumption (subjective factor
which is out of our analysis)
- Owners of capital [K is only in cloth production, so in the industry where P rise] – the
owners of specific factor will be better off if the increase in price occur within their
sector – in our example, Pc increased, so owners of capital are better off – the relative
price for cloth increases (because the nominator Pc increase)
- Owners of land [T is only in food production, so in the industry where P stay still] – the
owners of specific factor will be worsened off because the price of the good in which
the specific factor is used did not vary – the relative price of food decreased (because
the denominator Pc is higher)

Changes in relative prices have strong repercussions for the distribution of income, creating both
winners and losers.

Up until now we have examined the impact of relative prices on income, but domestically – in
absence of trade. So how citizens are affected by the price changes occurring within their country.
We now want to link this relative price change effect on income, with international trade setting.
Matching up the predictions for winners and losers in international trade.
International Trade in Specific Factors Model

For trade to take place, a country must face a world relative price that differs from the relative
price that would prevail in absence of trade (like in the previous analysis). This means that the
relative price obtained in the previous analysis – absence of trade – would be different from the
world relative price in case of trade taking place.

The graph is similar to the previous, however we add

the world relative supply curve.
The world supply curve differs from domestic relative
supply curve because different countries have
different technologies, but also different resources in
terms of factors of production (land, capital, labor).
What is important here is that when the domestic
economy is opened to trade, it faces different relative
prices.
Notice that also the relative demand is solely express
in global terms, however there are no differences in
RD across countries.

When the economy is open to trade, the relative price of cloth is determined differently from
before – in absence of trade. In case of trade the relative price of cloths Pc/Pf is determined by
their interception of RS world and RD world (Pc/Pf)2.
As we see, in absence of trade the price would be lower, at (Pc/Pf)1.

Opening up to trade – consequences for country x

Effect on RS and quantity supplied
The relative price of cloth increases  country x relative supply of cloth increases (Qc/Qf), as such
that it becomes larger than world’s relative supply
Effect on RD and quantity demanded
At the same time, consumers respond to higher relative price of cloth, by decreasing the relative
quantity of cloth demanded, and increasing the relative demand for food (lower relative price).

Recap: in case of trade, we see that relative price of cloth increases and relative price of food
decreases – in global terms.
Price of cloth in the international market is higher than by producing domestically in country x,
and price of food is lower in the international market than in country x.
Therefore, country x that opens to trade will  import food and export cloths
N.B. it exports cloths also because RS of cloth in country x increased while domestic demand for
cloth decreased – selling the surplus.
Similarly, it imports cloth because, by increasing the RS of cloth – increasing the resources used it
that sector – RS for food decreased domestically, but the lower price of food make it increase
domestic demand – it outsources the deficit

Opening to trade will increase the relative price of the good in the new export sector.

Income distribution and Gains from trade

Who gains and who loses from international trade? We begin by asking how welfare of particular
groups is affected, and then how trade affects the welfare of the country as a whole.
Opening to trade will increase the relative price of the good in the new export sector – we can link
this prediction with our results regarding how relative price changes, translate into changes in the
distribution of income.
We saw that the owner of the specific factor where relative price increases wins, while the owners
of the specific factor where the relative price decreased loses.
Impact of international trade on income distribution  trade shifts the relative price of cloth to
food, so factor prices change. trade benefits the specific factor related to the exported good (cloth,
thus K) of each country, but hurts the factor specific to the import-competing sector (food, T), still
with ambiguous effect of the mobile factor.

Do the gains from trade outweigh the losses?

Could those who gain from trade compensate those who lose and still be better off themselves? If
so, trade is potentially a source of gain for everyone

In order to show aggregate gains from trade, we need to state some basic relationships among
prices, production, and consumption.

In absence of trade, the output of goods produced must be equal to the goods consumed. Dc is
consumption of cloth and Df consumption of food, then in a closed economy Dc=Qc and Df=Qf.

international trade, instead, makes it possible for the mix Dc and Df,
to differ from Qc and Qf (produced). So, the amount of goods Qc= production of cloth
Qf= production of food
consumed and produced can differ.
What is produced is exported, what
However, the value of the output produced must be equal to the is consumed is imported
value of the output consumed – a country cannot spend more
(consumption) of what it earns (production).
Therefore, the following equation must be respected:

(Pc*Dc) + (Pf*Df) = (Pc*Qc) + (Pf*Qf)  the value of the output produced must be equal to the
value of the output consumed

Rearranging the equation:

Df – Qf = (Pc/Pf) * (Qc – Dc)  Df – Qf is the economy imports of food (in terms of quantity, not
value) - therefore the amount by which its consumption of food exceeds the production of food
(it’s the deficit of food to satisfy the population that is
outsources).
 (Pc/Pf) * (Qc – Dc) it represents the product of the
relative price of cloths and the amount by which cloth
production exceeds consumption (exporting amount).

This equation tells us that the amount the economy can

afford to import is limited, or constrained, by the amount it
exports – the equation is also known as budget constrain.
The budget constrains lies above the production possibility frontier.

The slope of the budget constrains is the negative relative price of cloth  consequence: one unit
of cloth can be exchanged in world market for Pc/Pf units of food.

The budget constrains is tangent to the PPF, so the economy can only afford to consume what it
produces

Point 2 is absence of trade, where consumption must be equal to production – this point must lie
on economy’s PPF.

Instead, if the economy can trade, the trading economy can consume more of both goods that it
would give in absence of trade.

The economy as a whole consumes more of both goods thanks to trade, so each individual can
consume more, everyone could better off.

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 better off
themselves
- That everyone could gain from trade does not mean that they actually go,
redistribution is hard to implement.

The Political Economy of Trade

As we saw, trade produces winners and losers. This insight is crucial to understand the
considerations to actually determine trade policy in the modern world economy.
Our specific factor model informs us that those who stand to lose the most from trade (at least
in the short run), are the owners of immobile/specific factors belonging to the import-competing
sector. In the real world, also some workers in the importing sector lose.
As said at the beginning, movement of labor is free but costly. This about that, some of the losing
workers have hard time transitioning from the import sector (where import/trade induces
reduction of employment domestically) to export sectors (where trade induces increases in
employment).
Unemployment spells as result.
In the US workers in the import sector earn wages substantially below the average wage, and
those workers earning the lowest wage face the highest risk of separation from their current
employer due to import competition (high probability of losing the job).
To face the disparity of wages of workers in the apparel sector, US poses limitations to import
apparel.
Optimal trade policy must weigh one’s group against another’s losses.

In spite of the real importance of income distribution, most economists remain strongly in favor of
more or less free trade.
There are three main reasons why economists do not generally stress the income distribution
effects of trade:
 - Income distribution effects are not specific to international trade. Every change in a
nation’s economy – including technological progress, shifting consumer preferences… -
affect income distribution within a country. Why should workers in the import-
competing sector who supper unemployment due to the increased income
competition, be treated differently from an unemployed printing machine operator or
an unemployed construction worker laid off due to housing slump?
- It is always better to allow trade and compensate those who are hurt by it than to
prohibit the trade. All modern industrial countries provide some sort of “safety net” of
income support programs (such as unemployment benefits and subsidized retraining
and relocation programs).
- The groups who stand to losses from increased trade are typically better organized than
those who gain in the export sector. The imbalance creates a bias in trade policy. Many
trade restrictions tend to favor the most organized groups, which are often not the
most in need of income support.

Most economists, while acknowledging the effects of international trade on income distribution,
believe it is more important to stress the overall potential gains from trade than the possible
losses to some groups in a country.

CASE STUDY – Trade and Unemployment

Opening to trade shifts jobs from import - competing sectors to export sectors. This process
however is not instantaneous and imposes some real costs. some workers in the import
competing sectors become unemployed and have difficulty finding new jobs in the export growing
sector. The best policy response is to provide adequate safety net to unemployed workers,
without discriminating based on the economic force that induced involuntary unemployment
(whether due to trade or technological change).
Here we quantify the extent of unemployment that can be traced back to trade. Unemployment
due to import is highly publicized but it accounts for a very small proportion of involuntary
workers displacements.
During 2001-2010, unemployment spells caused by either import competition or overseas
reallocations accounted for less than 2% of total involuntary displacements.

Over the last half century in US, there is no evidence of a positive correlation between the
unemployment rate and imports (in reality the correlation appears to be negative). The figure
shows, on the contrary, how unemployment is a macroeconomic phenomenon that responds to
overall economic conditions.
Therefore, the best way to reduce unemployment is by adopting macroeconomic policies to help
the economy recover, not by adopting trade restrictions.
Parenthesis
Workers move between the cloth and food sector within a country
until wages in the two sectors are equalized

Movement of factors of production

- Labour mobility
- Transfer of financial assets through international borrowing and lending
- Transactions of multinational corporations involving direct ownership of foreign firms

Like movement of goods and services (trade), movements of factors of production are politically
sensitive and are often restricted.

International Labour Mobility

Why labour migrate across countries? – whenever international migration is possible, workers will
want to move from the low-wage country to the high-wage country.

Explain causes and effects of international labour migration:

- Consider movement of labour across two countries,
- Let’s assume that two countries produce a single good with labour and an immobile
factor, land. Thus, labour can move across countries while land cannot
- Since there is only one good, there is no reason to trade it
- However, there will be trade in labour services when workers move in search of higher
wages.
- Difference in wages across countries are caused by differences in technology or
differences in the availability of land relative to labour.
 This graph represents the equilibrium
wage and labour allocation with
migration across countries.
- It is similar to the graph
that determined the
allocation of labour
between two sectors within
the same country

The horizontal axis represents the

total world labour force. The two MPL
curves represents production of the
same good in different countries. We
assume that wages measured on the
vertical axis are real wages (wage
divided the price of the unique good in each country).

Initially we assume that OL1 are home workers and L1O* are foreign workers. At OL1 and L1O*
employment levels (plus technology and land endowment differences), are such that real wages
are higher in Foreign (point B) than in Home (point C) – higher labour force at home but lower
wage, due to diminishing returns when increasing the number of employees (lower productivity).

Workers in Home country now wants to migrate to the foreign country where they can earn more.

Labour migrates from Home to Foreign until MPL=MPL*. At this point the labour employs in the
two countries for the production of the same good would be equalized, thus also wages in the two
countries would be equal.
The result is higher real wages at home and lower in the foreign country. However, point A
represent the equilibrium wage and allocation of labour across countries.
Workers at Home initially benefit while in Foreign are hurt by inflow of workers, this because
Foreign’s wage decreases as said.
At the same time, landowners in foreign gain from the inflow because they can decrease real
wages while increasing output. Instead, landowners are hurt by the outflow of workers, increasing
real wages and decreasing output.

However, it is almost impossible that they actually equalize, this because of restrictions in
immigration and natural reluctance to move – do not really reach the point A

Reaching the equilibrium, A increases the world’s output as a whole. Foreign output rises, while
Home’s falls. Since Foreign gain is larger (because foreign is more productive) that Home’s loss,
the overall world’s production increased.
Therefore, the value of world’s output is maximized when the marginal productivity of labour is
the same across the countries.
 Table 4-1 shows that real wages in 1870 were much higher in destination countries than in
origin countries.
 Up until the eve of World War I in 1913, wages rose faster in origin countries than in
destination countries (except Canada).
 Migration moved the world toward more equalized wages.

Immigration and the U.S. 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.

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:

- Factors of production cannot move costless and quickly from one industry to another.
- Changes in an economy’s output mix have differential effects on the demand for
different factors of production.

3. International trade affects the distribution of income 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.

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.
7. Labor migrates to countries with higher labor productivity and higher real wages, where
labor is scarce.
- Real wages fall due to immigration and rise due to emigration.
- World output increases.

8. Real wages across countries are far from equal due to differences in technology and due to
immigration barriers.