Gains and Losses from Trade in the Specific-Factors Model Readings: Chapter 3 1 Specific-Factors...
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Transcript of Gains and Losses from Trade in the Specific-Factors Model Readings: Chapter 3 1 Specific-Factors...
Gains and Losses from Trade in the Specific-Factors
ModelReadings: Chapter 3
1 Specific-Factors
Model 2
Earnings of Labor 3
Earnings of Capital and Land
4Conclusions
3
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U.S.-South Korea Free Trade Agreements
• Announced in December 3, 2010. • Tariff cuts are not uniform across sectors
• $1 billion of U.S. farm exports will become duty-free immediately
• But U.S. beef exports still faces a 40% tariff (to be phased out in 15 years)
• The U.S. tariff on auto imports (2.5%) will remain until the 5th year.
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Bolivian Politics and Trade
© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Specific-Factors Model
• Gains from trade are not evenly distributed across industries
• The specific-factor model helps explain who gain and who lose from trade
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Road Map
• Part 1 How does trade affect the Home country? Before trade With trade
• Part 2 How does trade affect real wages?• Part 3 How does trade affect the returns to
capital and land?
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Specific-Factors Model
• Home Country Manufacturing uses labor (LM) and capital (K)
Agriculture uses labor (LA) and land (T)
Labor moves freely between manufacturing and agriculture
Capital is “stuck” in manufacturing (i.e. it has NO USE in agriculture)
Land is “stuck” in agriculture (i.e. it has NO USE in manufacturing)
• Labor is the “mobile factor”• Capital and land are “specific factors”
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Diminishing Returns
• Manufacturing output and labor employment
Holding K fixed
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Diminishing Returns
Diminishing returns to labor – decreasing MPLM and MPLA
Holding K Constant
Holding TConstant
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Notes: Diminishing Returns
• Diminishing returns As more labor is used, the manufacturing output
goes up, but at a diminishing rate, holding K constant.
As more labor is used, the marginal product of labor in manufacturing, MPLM, decreases, holding K constant.
The statements for agriculture are analogous.
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
PPF and Slope
PPF is concave shapedFrom A to B:Loss in QA = -MPLA
Gain in QM = MPLM
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Notes: PPF and Slope
• Each country faces a standard Production Possibilities Frontier Concave to the origin due to diminishing returns
to labor in both industries The slope of the PPF is the ratio of the marginal
products Ratio is the opportunity cost of producing one unit of
manufacturing
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Wage Equation
• Wages Firms hire labor up to the point where the marginal
benefits equal the marginal costs
This relationship holds for both industries
AA
MM
MPLPW
MPLPW
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Relative Price Before Trade
• Since we assume that labor is mobile, the wages in the two industries must be equal.
• Relative price of manufacturing equals the opportunity cost of manufacturing (slope of PPF)
M M A A
M A
A M
P MPL P MPL
P MPL
P MPL
Thus as in the Ricardian model, |slope of the PPF|= the relative price of manufacturing= the Opportunity Cost of manufactured good
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
closed-economy equilibrium
U1
Manufacturing Output, QM
A
B
Agriculture Output, QA
PPF
Slope = –(PM/PA)
Home Country Before Trade
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Notes: closed-economy equilibrium
• Equilibrium for Home country is A. In equilibrium PM/PA = |slope of PPF|
Consumer’s indifference curve is tangent to PPF This is the same as in the Ricardian model
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Foreign Country
• Assume that the Foreign Country has the comparative advantage in the agricultural good; i.e. (PM*/PA*) > (PM/PA)
• Then at equilibrium with free trade, the equilibrium price (PM/PA)W falls between (PM*/PA*) and (PM/PA)
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Gains from trade
Slope = –(PM/PA)W
U1
Manufacturing Output, QM
A
B
Agriculture Output, QA
PPF
Slope = –(PM/PA)
Figure 3.4 b – Home Country w/Trade
C
U2
Gains from trade
The gains from trade can be measured by the rise in utility from U1 to U2.
Trade makes prices for manufacturing in Home rise as seen from new price line
Once trade is opened and consumer face the new world price, they are able to move to a higher indifference curve (U2).
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Equilibrium with Trade
Slope = –(PM/PA)W
U1
Manufacturing Output, QM
A
B
Agriculture Output, QA
PPF
Slope = –(PM/PA)
C
U2
Gains from trade
Old production – A
New production – B
Old consumption – A
New consumption - C
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Notes: Equilibrium with trade
• What has happened at Home? Relatively higher prices in manufacturing attracts
more workers to that industry - production now at point B (instead of A)
Manufactured goods are exported and Agricultural goods are imported
Consumption changes move individuals to a higher indifference curve, allowing them to now consume at C (instead of A)
Home does not completely specialize in manufacturing and still produces agriculture
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Application: How Large Are Gains from Trade
• Dec. 1807 ~ Mar. 1809, the U.S. imposed an embargo (a complete halt of international trade)
• Exports (cotton, tobacco, rice, etc.) dropped from $49 M to $9 M
• Cost of embargo estimated at 5% of U.S. GDP then In the great depression, loss in output was 9% of
U.S. GDP
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Summary of Part 1
• Diminishing Returns PPF is concave-shaped Home produces manufacturing AND agriculture
with free trade (no specialization) OC changes with output and labor employment
• Many results derived for Ricardian model still work Wage = price x marginal product of labor OC = relative price before trade (comparative
advantage)
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Earnings of Labor
• Although a country as a whole is better off from trade, that does not mean that every individual is better off
• How are earnings of labor (i.e. real wages) affected by trade?
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Labor Market Equilibrium
• Determination of Wages We can show the uses of labor in each industry
on one graph Uses of labor and wages are directly dependent
on the marginal product of labor Firms hire up to the point where wages equal the
value of the marginal product.
M AL L L
AA
MM
MPLPW
MPLPW
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Labor Market Equilibrium
Manufacturing
W = PMMPLM
LM
Agriculture
W = PAMPLA
LA
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Labor Market Equilibrium
PM*MPLM is drawn from left to right
PA*MPLA is drawn from right to left
Labor Market Equilibrium is where the two curves cross
PM PA K, L_bar and T Are given
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Notes: Labor Market Equilibrium
• As long as the labor market is in equilibrium, there is no reason for labor to move between sectors
• However, equilibrium can change as other factors in the markets changes
• Labor will move to the industry where it is paid (valued) more
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Effects of trade
• Change in Relative Price of Manufactures From no-trade equilibrium to trade equilibrium,
relative price of manufacturing good increases. (PM/PA)W > (PM/PA)
This can be caused by an increase in PM or a decrease in PA; effect on real wage is the same
Assume PM rises and PA does not change
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Effects of Trade
PM*MPLM shifts up creating a new equilibrium
The vertical distance between the old and new curves is greater than the increase in wages
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Summary: effects of trade
• Effect on Wage PM*MPLM curve shifts up by Δ PM*MPLM
New equilibrium at higher wage LM has increased and LA has decreased
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Real wages
• Home makes both mfg. and agr. With trade
W = PMW x MPLM = PA
W x MPLA
• Real wages equal marginal products of labor
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Real wage for Agr.
• LA falls,
• So MPLA rises
• So w/PA (= MPLA) rises
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Real wage for Mfg.
• LM rises,
• So MPLM falls
• So w/PM (= MPLA) falls
• i.e. wages “rises by less” than PM
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Summary: How does trade affect real wages?
• PM increases and PA does not change 0 M MA AP P W W P P
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Notes: How does trade affect real wages?
• Ambiguous We have cannot make unqualified statements
about the effect of trade on workers. The effect of trade on real wages is complex
Is labor better off or worse off after the price increase? A person who spends much of their income on
agricultural goods is probably better off and vice versa. In the specific-factors model, the overall effect on the
well-being of workers has an ambiguous effect.
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Summary: Steps We’ve Taken
• Want to see trade => real wages w• But wages depend on marginal products of
labor (e.g. W/PM = MPLM )
• Marginal products of labor, in turn, depend on labor employments (e.g. MPLM depends on LM)
• So we go
trade => LM and LA => MPLM and MPLA => real wages
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
How does trade affect Unemployment?
• No effect! Total labor is always LM + LA = so no
unemploymentL
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APPLICATION
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Employment Churning in the U.S. Economy
Source: U.S. Bureau of Labor Statistics, http://www.bls.gov/news.release/disp.nr0.htm
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Notes: How does trade affect Unemployment?
Why do we ignore unemployment?
Unemployment usually considered a macro phenomenon affected by business cycles
Many people laid off due to trade often find new jobs in a reasonable amount of time, sometimes with higher wages
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APPLICATION
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Trade Adjustment Assistance (TAA) Program
• Unemployment Insurance (UI) Involuntary unemployment State UI agencies. Up to 26 weeks and $390 per
week in Indiana, 2008.
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APPLICATION
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Trade Adjustment Assistance (TAA) Program
• Trade Adjustment Assistance http://www.doleta.gov/tradeact/benefits.cfm After normal UI is exhausted; employment related
to foreign competition; U.S. DOL Training: up to 104 weeks income support: 26 after UI, plus 52 if training job search and relocation expenses
• TAA is a small program In 2011, total expense $300 million, 27,000
workers (source: http://en.wikipedia.org/wiki/Trade_Adjustment_Assistance#Program_Cost )
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Summary: Part 2
• Labor Market Equilibrium• How does trade affect real wages?
Changes in LA and LM
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Earnings of Capital and Land
• Although there are “overall” gains from trade for the country, we know that the effect of trade on labor earnings is ambiguous.
• What happen to owners of capital and land?
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Earnings of Capital and Land
• Determining the Payment to Capital and Land We consider the value of the additional output we
get from hiring those factors, similar to the way we derive the wage equations:
MPKM is the marginal product of capital in manufacturing
MPTA is the marginal product of land in agriculture
AAT
MMK
MPTPR
MPKPR
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Marginal Products of Capital and Land
• MPKM rises (falls) if LM rises (falls)
• MPTA rises (falls) if LA rises (falls)
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Notes: Earnings of Capital and Land
• Determining the Payment to Capital and Land RK and RT are the rental on capital and land
respectively Rental reflects what these factors earn during a
given period when used in these industries Also, the amount the factors could earn if rented
to someone else over the same time
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Real Returns to Capital
• Capital is used in Mfg. only: RK = PM × MPKM
RK rises because (1) PM rises (2) MPKM rises (because LM rises)
• Real return in terms of Agr.: RK/PA
Rises because RK rises and PA doesn’t change
• Real return in terms of Mfg.: RK/PM = MPKM
Rises because MPKM rises (because LM rises)
Intuitively, RK “rises by more” than PM
Rigorously,
• Capital owners are better-off
M M K KP P R R
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Real Returns to Land
• Land is used in Agr. only: RT = PA × MPTA
RT falls because (1) PA doesn’t change (2) MPTA falls (because LA falls)
• Real return in terms of Mfg.: RT/PM
falls because RT falls and PM rises
• Real return in terms of Agr.: RT/PA = MPTA
falls because MPTA falls (because LA falls)
This means that
• Land owners are worse-off
0T T A AR R P P
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Intuition
• Why do capital owners benefit from trade?
(1) capital is specific to mfg. (2) interests of capital owners are tied to mfg. (3) mfg. expands with free trade
• Why do land owners lose from trade?
(1) land is specific to agr. (2) interests of land owners are tied to agr. (3) agr. contracts with free trade
• Assumptions: K and T do not change.
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Summary: Trade redistributes income
• General Equation for the Change in Factor Prices PM increases and PA does not change
KKMMTT RRPPWWRR 0
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Application: Prices in Coffee
• Price of coffee fluctuates wildly from year to year
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Application: Fair Trade Coffee
• In 1999, TransFair USA started offering fixed prices to coffee farmers in Central America, bypassing middle men
• This fair-trade coffee gained momentum following the collapse of coffee price in 2001
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Application: Fair Trade Coffee
• In 2005, however, coffee prices recovered in the world market
• The fixed price offered through fair trade arrangements was lower than the prices offered by middlemen
• Coffee growers were torn between being loyal to the fair-trade contract, and delivering to middlemen for higher earnings.
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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Summary Part 3
• Rentals of capital and land Capital owners gain from trade because trade
expands mfg. (K does not change) Land owners lose from trade because trade
contracts agr. (T does not change)
• Comparison of percentage changes in PA, PM, w, RT and RK.