1. © 2007 Pearson Addison-Wesley. All rights reserved Chapter 5 Factor Endowments and Trade I: The Specific Factors Model

2. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. Preview H-O model 2 by 2 --LR Specific model: 3 by 2 — SR Technology: homogenous degree of one  CRS Market structure: perfect competition Y1=f(K1, L1); Y2=f(K2, L2) Labor equilibrium condition Profit=p1Y1-WL1-r1K1

3. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. Transformation Schedule Labor is used to produce both food and clothing. Land is used only in food, and capital is specific to the clothing sector. Quadrant III shows a 45 degree line to illustrate the allocation of labor in the two sectors. Quadrants II and IV show diminishing returns to labor when the other factor used is fixed (capital for clothing and land for food). Endpoint D (F) shows the maximum amount of food (clothing).

4. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. Figure 5.A.1 Production Possibilities with Diminishing Returns and Increasing Opportunity Costs

5. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. Transformation Schedule The PPF in quadrant I is derived by picking a labor allocation along the full-employment line (QIII) and displaying the output of food (QII) and clothing (QIV) obtainable in Q1. Diminishing returns lead to increasing opportunity cost. Consider a move from N to N ’ that an extra labor moves from food sector to clothing sector. As extra labor is poured into the clothing sector, diminishing returns decrease labor ’ s productivity.

6. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. Transformation Schedule Meanwhile, the departure of labor from the food sector raises the productivity of the remaining food workers. On both counts, the relative cost of producing clothing increase. The PPF becomes more steeper. Its slope equals (minus) labor ’ s marginal product in food divided by its marginal product in producing clothing.

7. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. Figure 5.1 Production Possibilities with Increasing Opportunity Costs

8. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. W=P 1 *MP L1 W=P 2 *MP L2 Product function is increasing and concave. L1 up, MPL1 down Diminishing returns to Marginal labor product K1 up, L1 down, MPL1 up ( Wicksell ’ s Law)

9. 5-9 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Output and Income Distribution w/ Free Trade Suppose clothing is relatively expensive on world markets. Accordingly, clothing output expands from N to N’. Keeping the price of food unchanged while raising the price of clothing, say 20%. VMP L of clothing shifts up at the same proportion (20%). If labor could not be reallocated between sectors, then a 20% wage gap happens in the two sector (segment DE). Labors are free to move between sectors. The move of labor changes the MP L between each sector.

10. 5-10 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 5.2 Wage Rate Determination

11. 5-11 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Who Gain and Who lose? Wickseller’s Law: the marginal product of one factor will increases when the other factor used increase. Owners of capital win. R=p*MPk The MPk increases when labor up in the clothing sector. Price also increases 20%. The return on capital must increase more than 20%.

12. 5-12 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Who Gain and Who lose? Owners of land lose. Rent=p*MPt The MPt decreases when labor down in the clothing sector. The food price also relatively decreases. The return on capital must increase more than 20%.

13. 5-13 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Wage Rate Determination Equilibrium wage (at A) equate the values of the marginal product of labor in the two sectors by labor allocation at G. If free trade raises clothing’s price, labor shifts out of food into clothing (from G to G’). The wage rate rises but not as much as clothing’s price. In each sector the price (unit cost) change must be flanked by the relative changes in favor rewards for inputs used in that sector.

14. 5-14 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Growth in Factor Endowments When one specific factor expands, what happens to the output that uses this sector? Say, Land increase 50% The VMP L will increase 50% given price ratio doesn’t change (“others constant”). It then increases the wage rate. It also increases the production of food since more land and more labor employed.

15. 5-15 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 5.3 An Increase in Land

16. 5-16 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. K1 INCREASES  Y1 ? Specific endowment increases  L1 up,  y1 up K2 fixed, but L2 down,  y2 down Rybcyznski theorem still holds!

17. 5-17 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Growth in Factor Endowments Then what happens for the PPF? The PPF shifts outward but in a biased direction. The new transformation curve would have the same slope as at N’ at a point northwest of N’—with more food and less clothing.

18. 5-18 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 5.1 Production Possibilities with Increasing Opportunity Costs

19. 5-19 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. What happens when Labor increases? An increase in the labor force would slide these schedules farther apart.

20. 5-20 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 5.3 An Increase in Land

21. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. L INCREASES  Y1 ? W W P1MPL1 O1 O2

22. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. L INCREASES  Y1 ? Y2 ? L1 up, K1 fixed,  y1 up W down  MPL2 down  L2 up,  y2 up An increase of mobile factor (labor) does not have the Rybcyznski effect. The equilibrium wage decreases. Each sector would respond to hiring more labor at the lower wage. Outputs in both sectors increase.

23. 5-23 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Consequences for Political Economy Any increase in land or capital serves to increase the wage rate and thus to drive down the returns to both specific factors. An increase only in labor force serves to lower the wage rate and drive up the returns to both land and capital. If factor endowments change (say, via immigration) but world commodity prices remain constant, the fortune of the specific factors (land and capital) rise or fall together and are opposed to those of the mobile factor (labor). Landlord and capitalists in legislation would lobby for immigration whereas labor union might oppose. –1920s US tight immigration restrictions –Australia’s liberal immigration policy

24. 5-24 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Consequences for Political Economy If world commodity price ratios change, the returns to the specific factors are driven widely apart, whereas the wage is relatively unaffected. Examples: –Corn Law in 19th century Britain –Agriculture in Nowtoday Japan

25. 5-25 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Figure 5.4 The “Dutch Disease”

26. 5-26 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. The “Dutch Disease” A boom in a new export sector raises wages. It then shifts costs upward for a traditional export sector Returns to capital are squeezed and output falls. This is different from the Ricardian model which predicts that a wage rise would cause the complete collapse of any tradable sector facing fixed world prices. In specific factor model, the industry may survive but only if lower returns are accepted by specific factors.

27. 5-27 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Fate of Non-tradable Sector One of the limitation of the Ricardian Model is the lack of Non-tradable sector. In Specific factor model, when one export sector expands due to an increase of export price, the non-tradable sector also experiences a cost increase. Consider two cases Without demand shift: the cost increases lead to an increase of price of the non-tradable sector. These cost increases could be partially passed on to consumers, with output reduced.

28. 5-28 Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Fate of Non-tradable Sector With demand right shift: With an export boom cased by a price rise, the economy’s real income expands with the favorable movement in the terms of trade. This will partly spill over to increased demand in the non- tradable sector. This push a much higher equilibrium price.