1. Trade, Distribution, and Welfare
Chapter Four
Trade, Distribution, and Welfare
Copyright © 2003 South-Western/Thomson Learning

2. Chapter Four Outline
Introduction
Partial and General Equilibrium Analysis
Stolper-Samuelson Theorem
Factor Price Equalization Theorem
Specific Factors Model
Trade and Welfare: Gainers, Losers, and Compensation

3. Introduction
Time to examine some of the major contributions international trade theory has made to general-equilibrium analysis.
We will look at the primary reason for the controversy between policies of free trade and policies of protectionism.

4. Partial and General Equilibrium Analysis
Interrelationships among various markets in the economy.
Extreme example would be a model of a world economy that includes every good, every input, and every country and in which everything depended on everything else.
Partial-equilibrium analysis
Focuses on events in one or two markets and assumes others remain unaffected.
Simple example: analysis of effect of a Florida freeze on prices of orange juice.

5. Effect of Output Prices on Factor Prices
Stolper-Samuelson Theorem
Link between changes in output prices and changes in factor prices.
Most general form: an increase in the relative price of a good increases the real return to the factor used intensively in that good’s production and decreases the real return to the other factor.
Factor prices change proportionally more than output prices (magnification effect).

6. Figure 4.1: How Does Trade Affect the Demand for Inputs in a Labor-Abundant Country?K A r A w A 2 D A r A L1 2 D A L2 w A D A D A K0 K2 D A D A L0 K1 L A L K A K
(a) Labor Market
(b) Capital Market

7. Effect of Output Prices on Factor Prices
In Figure 4.1, as production of the labor-intensive good increases, opening trade generates a net increase in demand for labor.
Net effect on demand for capital is negative, because production of the capital-intensive good falls.
With fixed factor endowments, the reward paid to the abundant factor rises and that paid to the scarce factor falls.
The wage-rental ratio under restricted trade exceeds the ratio under autarky.

8. Effect of Output Prices on Factor Prices
When assumptions of Heckscher-Ohlin model are added, the Stolper-Samuelson theorem means that opening trade raises the real reward to the abundant factor and lowers the real reward to the scarce factor.
Trade boosts production of the good of comparative advantage, increasing that good’s opportunity cost and relative price.
See Table 4.1 for trade’s effects on production, output prices, and factor prices.

9. How Do Factor Prices Vary Across Countries?
The Factor Price Equalization Theorem
According to Stolper-Samuelson theorem, moving from autarky to unrestricted trade raises the real reward of the abundant factor.
Similarly, such a move lowers the real reward of the scarce factor.
Same adjustment takes place in the second country, but with the roles of the two factors reversed.
Trade raises the real reward of a factor in a country where that factor is abundant and lowers its price in the country where it is scarce.

10. How Do Factor Prices Vary Across Countries?
Thus, even when factors are immobile between the two countries, unrestricted trade in goods tends to equalize the price of each factor across countries.
With free trade in goods and no international factor mobility, wA = wB and rA = rB.
This is idea behind Factor Price Equalization Theorem.
Table 4.2 (page 111) summarizes the theorem’s implications, assuming country A is labor-abundant and good X is labor intensive.

11. How Do Factor Prices Vary Across Countries?
Figure 4.2 illustrates how a firm’s cost-minimizing production techniques change.
To increase production of the labor-intensive good (X), firms in both industries must increase their capital-labor ratios.
The rise in wage-rental ratio from (w/r)0 to (w/r)1 brings about this adjustment.
Firms choose to use less labor and more capital as labor becomes more expensive relative to capital.

12. Figure 4.2: Changes in Factor Cause Firms to Change Their Capital-Labor RatiosK K X Y
Slope = –
(w/ r)
Slope = –
(w/ r) 1 1
(K/L) Y1
(K/L) X1
Slope = –
(w/ r)
Slope = –
(w/ r)
(K/L)
(K/L) Y0 X0 X Y L L X Y
(b) Y Industry
(a) X Industry

13. How Do Factor Prices Vary Across Countries?
The factor price changes predicted by the factor price equalization theorem provide the firm an incentive to undertake the necessary changes in production techniques.
Profit-maximizing firms will choose to use more of the scarce factor as it becomes relatively cheaper and less of the abundant factor as it becomes relatively more expensive.
This “economizing” on use of the abundant factor allows the country to specialize in producing the comparative advantage good.

14. An Alternate View of Factor Price Equalization
Trade in outputs serves as a “substitute” for trade in factors of production.
For example, when a labor-abundant country exports a unit of a labor-intensive good, it indirectly exports labor to a labor-scarce country.
Unrestricted trade in either output or input markets can serve as a substitute for trade in the other markets.

15. Why Don’t We Observe Factor Price Equalization?
Full factor price equalization is never observed.
In Figure 4.3, it is shown that wages, before corrections for differences in labor productivity, differ widely across countries (by a factor of 20).
Reason #1: Uneven ownership of human and nonhuman capital yields inequality of wealth.
Reason #2: Not all countries use identical technology in production…some are more advanced than others.
Causes factor productivity to vary across countries.

16. Figure 4.3: Hourly Compensation for Manufacturing Production Workers, 1999 (U.S.=100)

17. Why Don’t We Observe Factor Price Equalization?
Figure 4.4 shows that relative factor price differences across countries match relative productivity differences.
Countries with high (low) labor productivity relative to that of the U.S. have high (low) wages relative to the U.S.
Countries with high (low) capital productivity relative to the U.S. have high (low) rental rates.

18. Figure 4.4a: Factor Prices Reflect Productivity
Wage/U.S. Wage
(a) Labor Productivity and Wages
1.2
Canada
1.0 US
Austria
Switzerland
New Zealand
Netherlands
0.8
Italy
Denmark UK
Belgium
W. Germany
Japan
Sweden
Norway
0.6
Israel
Ireland
Spain
France
Finland
0.4
Greece
Singapore
Portugal
Colombia
Panama
Hong Kong
Indonesia
0.2
Yugoslavia
Thailand
Pakistan, Sri Lanka
Bangladesh
0.2
0.4
0.6
0.8 1
1.2
Labor Productivity/U.S. Labor Productivity

19. Figure 4.4b: Factor Prices Reflects Productivity
Rental Rate/U.S. Rental Rate
(b) Capital Productivity and Rents
1.8
1.6
Sweden
1.4
Norway
Japan UK
Hong Kong
1.2
Netherlands
Switz.
Denmark
Austria NZ
1.0
Singapore
Greece
Ireland
U.S.
Spain
Canada
Italy
Yugoslavia
Trinidad
Portugal
Israel
0.8
Panama
Bangladesh
Thailand
Pakistan
Belgium, Finland, Germany
0.6
Colombia
Uruguay
0.4
Indonesia
0.2
Sri Lanka
0.2
0.4
0.6
0.8 1
1.2
Capital Productivity/U.S. Capital Productivity

20. Why Don’t We Observe Factor Price Equalization?
Complete output price equalization may not occur due to transportation costs, barriers to trade, and existence of goods that are rarely traded.
The factor price equalization theorem suggests an important policy alternative:
Allow free trade in outputs, specialize in labor-intensive production, and export labor indirectly in the form of labor-intensive goods.
Countries such as Ireland, the Philippines, India, Jamaica, and Singapore have begun using new technologies to do just that.

21. What if Factors Are Immobile in the Short-Run?
Previous assumptions were that factors are completely mobile among industries within a country and completely immobile among countries.
In the short-term, mobility of factors may be imperfect.
Short-run effects of opening trade may differ from long-run effects captured by Stolper-Samuelson and factor price equalization theorems.

22. Reasons for Short-Run Factor Immobility
Physical capital: machines and factories
Most equipment is specialized…it is suited only for the specific purpose for which it was designed.
As physical capital wear out from use and age, firms set aside funds (depreciation allowances) to replace the equipment.
Funds can be used to buy a different type of capital.
Labor capital – same arguments apply.
As older workers retire and new ones enter the labor force, the skill distribution slowly changes in favor of growing industries and away from shrinking ones.

23. Effects of Short-Run Factor Immobility
Figure 4.5 illustrates that an increase in the price of shoes raises the wage rate in both the shoe and the computer industries, but by less than the rise in the price of shoes.
The return to capital specific to the shoe industry rises more than proportionally with the price of shoes, and the return to capital specific to the computer industry falls.

24. Figure 4.5a: Effect on Factor Markets of an Increase in an Output Price with a Specific Factor
VMP L s1
VMP L s0
VMP L c0 L L s 2 c L A
(a) Labor

25. Figure 4.5b: Effect on Factor Markets of an Increase in an Output Price with a Specific FactorSK A r s r s2 r s1
VMP SK 2 r
VMP SK s0 1
VMP SK SK
(b) Shoe Capital

26. Figure 4.5c: Effect on Factor Markets of an Increase in an Output Price with a Specific FactorCK A r c r c0 r c1
VMP CK
VMP CK 1 CK
(c) Computer Capital

27. Figure 4.8: General-Equilibrium Linkages in Our Basic Trade Model
Gains from Trade
Terms of Trade (P /P ) tt X Y
Productive Specialization
Comparative Advantage
Output Prices
Output Prices (P /P ) A (P /P ) B X Y X Y
Heckscher-Ohlin
Theorem
Stolper-
Stolper-
Samuelson
Samuelson
Theorem
Theorem
Factor Prices
Factor-Price
Factor Prices
Incomes
Incomes
(w/r) A
Equalization Theorem
(w/r) B
Demand for
Demand for
Supply of
Supply of
Demand for
Demand for
Outputs
Factors
Factors
Factors
Factors
Outputs
Tastes
Technology
Endowment
Endowment
Technology
Tastes U A
(X,Y) a
, a
, a
, a L A
, K A L B
, K B b
, b
, b
, b U B
(X,Y) LX KX LY KY LX KX LY KY