1. Specific Factors Model

2. 2 Outline 1.Objective3 2.Assumptions4 3. Production possibilities.5 4. How much labour will be used in each sector?6 5. Factor price equalization within a country9 6. Factor price equalization between countries13 7.Uncertainty16 Model17 Case 117 Case 220

3. 3 1. Objectives -Study International trade effects on income distribution inside a country. -Study efficiency and distribution effects of factor mobility : Factors can not move immediately and costless from one sector to another as theory assumes. At the same time the different proportion of factors needed to produce each good implies that trade benefits some sectors in the economy while prejudicing others. For this reason we will focus the study of specific factor model on the factor price equalization within countries and between countries. -Study political support for reform under certainty (according to factor ownership) and under uncertainty (according to expected mobility and gains).

4. 4 2. Assumptions 2 goods j: manufactures and food. 3 production factors: labour (L), capital (K) and land (T). Labour is a mobile factor, while capital and land are specific factors designated to the production of manufactures and food respectively. For given levels of the specific factors each good has decreasing returns to scale on labour. Production functions are: K and T are the economy supply of capital and land. The economy supply of labour is: for manufactures for food

5. 5 3. Production possibilities. As specific factors are fixed for each good’s production, the output will depend on the distribution of labour between the two goods production. The marginal product of labour is decreasing. Manufactures production function QMQM LMLM MPL M LMLM Marginal product of labour The same can be represented for food sector.

6. 6 4. How much labour will be used in each sector? It will depend on the goods prices, as well as the wage level. The wage is determined by the demand of labour of both production sectors. The demand for labour in each sector is given by the maximization problem of producers which implies that the value of an additional unit of work equals it’s cost: where: is the marginal product of labour in production of good j. is the price of good j. is the wage level. This is that the value of marginal product of labour equals the wage level. For given levels of p M and p F the value of marginal productivity of labour in the production of both goods can be represented by a downward sloping curve.

7. 7 MPL M LLALA A wAwA Income distribution Represents the income of labour. Represents the income of capital (“surplus” of the employer). + Represent the total product

8. 8 As we assume that labour moves freely between sectors, wage level will be equal for a worker in manufactures and in food production. E MVPL M MVPL F wEwE LELE Labour used in manufactures: L M Labour used in food: L F Total labour supply Demand for labour in food. Demand for labour in manufactures.

9. 9 5. Factor price equalization within a country Situation B is inefficient as: If we move one worker from food sector to manufactures, then the production that is destroyed in the food sector is lower than the added in manufactures. There is a gain for the society until point E is reached. MVPL M MVPL F BMBM BFBF E 5.A. Efficiency issues

10. 10 Why there are barriers that keep the situation B? There are sectors that resist to move from B to E: both workers from manufacture sector and land owners from food sector are not willing to reduce their income. Better organized workers in unions get better wages. There is a social conflict as there are two social classes that do want the change: workers from food sector and capital owners from manufacture sector.

11. 11 MVPL M MVPL F D LMLM C E LFLF L’ M L’ F Which is the effect in purchasing power of a manufacture prices increase? Income of K increases (surplus larger) and income of T decreases. These factors are “specific” : they suffer a strong “Stolper-Samuelson” effect. The value of marginal product of mobile labour increases in the manufacture sector and the nominal wage increases in both sectors. 5.B. Adjustment to shocks and changes in purchasing power

12. 12 As prices in the food sector remained equal, the purchasing power of workers in terms of food has increased, but what happens with the purchasing power in terms of manufactures? If all the variation in price of manufactured products is transferred to wages then the wage level should be w D, higher than w C. Thus at W C, the purchasing power of wages in terms of manufactures has decreased. Total effect in purchasing power is uncertain, as it also depends on the consumption goods basket ( see point 7: Uncertainty).

13. 13 6. Factor price equalization between countries MVPL F MVPL M Europe By trading with the rest of the world, European workers will see their welfare reduced when factor price equalization takes place. At the same time in the rest of the world capitalists (owners of scarce factor there) will be worse too as they will reduce part of their profits.

14. 14 Trade Wages decrease in Europe and increase in the rest of the world. Investment remuneration increase in Europe and decreases in the rest of the world. Factor mobility: abundant factor in one country moves to where it is scarce. Then the two factors capital and labour will move in opposite directions: capital moves from the North to the South and labour moves from the South to the North. However, factor mobility is not possible, goods make the work of factor price equalization but full price equality won’t happen.

15. 15 Migration can increase unemployment, which happens because it destroys output in the home country and does not increase it in the host country (where minimum wage laws or unemployment benefits operate). In the host country, marginal product can sometimes decrease fast because firms are not well equipped to hire more workers; cities are not equipped in terms of housing, electricity and water supply, environmental management, etc. Both, no migration or too much migration are counterproductive for the economy.

16. 16 How does uncertainty determine the support to policy reforms? (Fernandez and Rodrik, 1991) FERNANDEZ, Raquel and RODRIK, Dany (1991) "Resistance to Reform: Status-Quo Bias in the Presence of Individual-Specific Uncertainty" American Economic Review 81, 5 (Dec.) 1146-1155 The presence of individual-specific uncertainty can distort aggregate preferences. Policy reforms are more likely to be adopted the more individuals are in favor of it. However, reforms are not adopted even though: Individuals are risk neutral. A majority could vote for it ex post. The previous two conditions are common knowledge. 7. Uncertainty

17. 17 Model 2 sectors: winner (W) and loser (L). Distribution of people among sectors: gains for W and losses for L. After a reform some agents will move from L to W, but a priori they don’t know who is going to be a lucky mover. The reforms bring aggregate gains anyway (expected gains of W > expected losses of L and realized gains of W’ > realized losses of L’). Case 1: Group L will decrease it’s income in 20% and W will increase it in the same amount. Then, the after-reform variation of income is: - 0.08 + 0.12 = 0.04. Final gain of the reform is positive in aggregate, ex post. Will there be a majority voting for it? (ex ante support) Initially: L>W (60 % L and 40 % W). After reform: L’<W’ (40% L’ and 60 % W’).

18. 18 To get the reform done 50% of the votes are needed: Ex post Ex ante L Losers Winners Expected gains of group L: Group L will not vote for the reform ex ante, then the reform will not take place. It is necessary to distinguish a priori winners and losers in order to get the reform done. 1 0,5 - 0,2 0,2 0.60.4

19. 19 If the reform is imposed, then there are net gains: -0.4  0.2 + 0.6  0.2 = - 0.08 + 0.12 = 0.04. The uncertainty about the final effects makes people vote against the reform. If a dictator impose the reform, this will take place and net gains will take place in aggregate and for a majority (here 60%). A majority (60% here) will support the new regime, provided a way is found to get there. Status quo bias works in two ways: 1.A reform that ex ante seems to deteriorate the situation of a majority will not be approved even if ex-post it would find majority support and bring aggregate gains. 2.A reform that ex-ante seems to bring gains to a majority (or to all) can be rejected in a second vote, if it does not improve the situation of a majority ex-post, even if it brings aggregate gains ex-post as well as ex-ante (see case 2).

20. 20 Case 2 Reform is voted when expected gains are positive for everybody, even when after the reform group L has lost. Initially: 10% sure winners, 90% unsure, but 0.2/0.9 will gain a lot (0,3) and 0.7/0.9 will lose a bit (0,067) : W>L (100 % are W in expected value). Finally: 70 % L and 30% W.

21. 21 10,7 - 0,067 0,3 0,015 Ex post Ex ante 0.9 Net effect ex-post : Minority’s gain > majority’s loss : aggregate gain, but rejected in second majority vote due to 70% of losers ! However, the expected total gain was positive: and the ex-post losers had an expected gain ex-ante : N.B.

22. 22 The reform takes place, but once it is adopted it has negative effects for many people (70% lose 0.067). Initially these voters vote against their interest. If there is a second chance they will reject the reform. If there was risk aversion, L would initially reject the reform because they have big probability of being among the 70% that loses. For beneficial reforms (case 1), uncertainty is the problem, not risk aversion. Since no new information is revealed, when a reform has been rejected a majority will keep rejecting it. On the importance of redistribution (or compensation principle) see also the insurance argument developed in Rodrick, D. (1998) "Why do more open economies have bigger governments?" Journal of Political Economy, 106, 5 997-1032