Chapter 4: Who Wins and Who Loses from Trade ? Important questions in this chapter: Who wins and who loses from trade in the short and in the long run? How trade affects factor prices - The Stolper- Samuelson theorem The factor price equalisation theorem The H-O model and actual trade patterns - the Leontief paradox

Trade and factor prices Recall that trade arises because factor inputs and factor prices are different between nations Labour is ”cheap” in countries well endowed with labour, and capital is ”cheap” in countries well endowed with capital Trade will affect prices of finished goods, and then factor prices must change too, meaning there will be winners and losers from trade within a nation

Short run effects of trade What do we mean by ”the short run?” In traditional microeconomics, the short run means a period where supply of at least one factor of production (capital) is fixed Let`s assume that the short run is even shorter - all factors of production are fixed Then it is safe to assume that all factors employed in the import competing sector will lose, and those employed in the export sector will gain

Trade in the long run In the long run, factors of production (even capital) can move between sectors Suppose the US has a comparative advantage in wheat, and the ROW in cloth Wheat is cheap in the US, and cloth is cheap in the ROW The US will export wheat to the ROW, and import cloth Production of wheat is capital intensive (land), production of cloth labour intensive

Trade in the long run When trade starts, US production of wheat will increase, and production of cloth will decrease Factors of production will move from the cloth sector to the wheat sector, because the wheat sector has become more profitable How does this affect factor prices ?

What will happen in the US ? Pre trade, W is cheap and C expensive With trade - the US will export W to the ROW Increased demand for W - price will increase, increased supply of C, price will fall In response to prices, production of W will increase, production of C will fall

What will happen in the US ? Recall: W is capital intensive, C is labour intensive When production of C decreases, ”a lot” of labour and ”a little” capital will be released When production of W increases, ”a lot” of extra capital and ”a little” more labour will be needed

What will happen in the US ? More workers released from C than what is demanded in W - supply > demand, wages will fall More capital demanded in W than what is released from C, demand > supply, rents will rise In the US, workers lose and capital owners gain from trade

What will happen in the ROW ? In the ROW, the opposite changes in prices and production will take place Production and prices of C will increase, production and prices of W will fall Since C is labour intensive, workers will gain and capital owners lose

Winners and Losers

What does this mean? Owners of the production factor used intensively in the production of the export good will gain, owners of the production factor used intensively in the import good will lose Trade makes factor prices equal between countries

Stolper - Samuelson A change in good price raises the real returns to the factor used intensively in the production of that good, and lowers the real return to the factor used intensively in the production of the other good The factor price which increases, increase relatively more than the price of the good

Stolper – Samuelson, contd. Lets use the following symbols: a = land used to produce 1 W b = labour used to produce 1 W c = land used to produce 1 C d = labour used to produce 1 C r = rental rate on land w = wage rate Pwheat and Pcloth are goods prices

Production costs and prices Since we assume competition, it must be that marginal costs of production equals price PW = ar + bw PC = cr + dw Assume the price of wheat increases by 10 % Returns to at least one factor must increase Safe to assume that land prices (r) will increase since land is used intensively in the production of wheat Since the price of cloth is unchanged and the price of land has risen, wages (w) must fall. Since the price of wheat has increased by 10 % and w has fallen, r has to increase by more than 10 %

Factor price equalisation Trade will equal not only goods prices but also returns to homogenous factors of production between countries This is definitely not what we see in real life, but at the same time there is little doubt that trade has narrowed factor price differences

Factor endowments

Wassilly Leontief (1906-1999) Nobel Prize 1973 Does the H-O model actually explain trade patterns ? Leontief assumed and tested The US is well endowed with capital The US should export capital intensive goods and import labour intensive goods The opposite appeared to be true – hence the Leontief paradox