Factor-proportions theory

Countries have different endowments of factors of production some are capital-abundant (high K/L) some are labor-abundant (low K/L)

Different industries have different requirements for K and L some are capital-intensive some are labor-intensive

Text example (modified)

Machine production is capital-intensive in both U.S. and India K/L = 2

Cloth production is labor-intensive in both U.S. and India K/L = 0.5

U.S. is capital-abundant and therefore has a comparative advantage in machine production

India is labor-abundant and therefore has a comparative advantage in cloth production

Perfect mobility is assumed

Labor can move from cloth production to machine production with no delay and no retraining

Capital equipment can move from cloth production to machine production with no delay and no modifications

The other extreme would be perfect specificity: cloth laborers or cloth machines useless for machine production and vice versa

No trade yet

Machine industry is capital-intensive: K/L=2

Cloth industry is labor-intensive: K/L=0.5

Trade opensMachine industry wants to expand due to new foreign demand

Cloth industry must contract due to foreign competition

Industries adjust to new marketMachine industry can use all the freed-up K but not all the L

Cloth industry is half its former size

Some workers are now unemployed

There is now a surplus of labor and a shortage of capital

The labor surplus is (theoretically) cured by a fall in wages, which motivates reduced labor market participation.

The capital shortage is cured by a rise in rents, which motivates more saving and investment.

Bottom line: opening of trade has reduced the income of the scarce factor of production (labor) while increasing the income of the abundant factor of production (capital)

Stolper-Samuelson “theorem”

Further consequences

The rise in rents and fall in wages motivates both industries to reduce their K/L ratios.

The opposite will happen in India. The shift in production will lead to a surplus of capital and a shortage of labor. Consequence: falling rents, rising wages. K/L will rise in India.

Generalizing: trade will tend to equalize K/L ratios in the two countries. Each country’s industrial structure will shift – U.S. moves away from cloth toward machines; India vice versa

Falling wages? No way!

Labor unions will not tolerate falling wages.

But absolute wages will not likely fall. Increasing labor productivity leads to higher wages which tend to mask fall in wages due to shifted industrial structure.

How about bribery?

Samuelson: laborers or others who are harmed by opening of trade could be given “hush money” gotten from taxes paid by the general public which benefits from opening of trade. This could be a “fairer” distribution of the gains from trade

Reality (“Trade Adjustment Assistance”):

Massive rent-seeking opportunity – everyone who loses his job will blame foreigners

Research shows no significant benefit

Bureaucrats are the real beneficiaries as usual

Labor mobility, capital mobility

We have assumed perfectly mobile labor – all workers in the cloth industry can instantly relocate to the machine industry with no delay and no loss of productivity

Also perfectly mobile capital – all machines formerly used in the cloth industry are equally useful in the machine industry

What if capital were perfectly specific

Suppose equipment used in the cloth industry were useless for machine production, and equipment used for machine production were useless for cloth production

If workers retain perfect mobility they will have an advantage that leads to higher wages

Reality: most workers can be retrained at some cost and are therefore neither perfectly mobile nor perfectly specific

Reality: some capital can be redeployed in new industries; almost all capital has some scrap value

Oops – the Leontieff paradox

One would expect U.S. to export capital-intensive goods and import labor-intensive goods. Leontieff found the opposite. Some reasons:

Natural resources were are not part of the (K,L) model. The U.S. imports some natural resources which tend to be capital-intensive

Labor-intensive industries typically benefit from trade protection

U.S. labor force is highly skilled, but the model assumes homogeneous L

U.S. also enjoys advanced technology