Chapter 6 TRADE AND LOCAL INCOME DISTRIBUTION: THE ...

Chapter 6
TRADE AND LOCAL INCOME DISTRIBUTION:
THE SPECIFIC FACTORS MODEL
One of the main implications of the Ricardian model is that everyone is better off with free
trade. Workers can earn higher wages by specializing in the goods that they produce most
efficiently, and consumers can purchase goods at lower prices in world markets. A quick
glance at the debates in the press over the merits of participating in trade and the demands
of certain groups for protection from international competition suggests that the situation
in the real world is not quite so straightforward. Are people simply unaware of the
benefits of trade, or are there some costs to trade that have been overlooked so far?
The specific factors model allows us to look at the effects of trade on the incomes of
different groups. In this model three factors of production are used to produce food and
clothing: land and capital, which are specific to the food and clothing industries,
respectively, and labor, which is mobile between the industries. The presence of specific
factors tends to cause a country to continue producing both goods after it opens to trade,
though probably in different proportions than in autarky. This contrasts with the
Ricardian model, in which countries tend to completely specialize.
The model also reveals that trade (and trade policy) can have very different effects on
different groups in the economy. In general, we find that specific factors enjoy larger
gains than mobile ones when their sector benefits from trade, but also suffer more when
their sector is harmed by trade. Because labor can move between sectors, the effect on
wages is moderated or indeterminate.

SHORT-ANSWER QUESTIONS
In answering questions 1 to 9, assume that the country is small, land is specific to food
production, capital is specific to clothing production, and labor is used in both industries.
In addition, assume that landowners, capitalists, and laborers spend half of their income on
food and half on clothing.
For questions 1 to 3, explain why each statement is true or false.
1. Workers are unambiguously worse off as a result of rising food prices because
their cost of living has increased.
2. An increase in the endowment of one of the specific factors causes both specific
factors to be worse off.
3. When the price of clothing rises, the return to capital rises by less than the price of
clothing because now more capital is employed, depressing the increase in the
return to capital.
4. An increase in the supply of capital will lead to:
(a) an increase in the return to land.
(b) a decrease in the wage rate.
(c) an increase in the wage rate.
(d) (a) and (b).
(e) (a) and (c).
5. An increase in the price of food will lead to:
(a) an increase in the real income of landowners and a decrease in the real
income of workers and capitalists.
(b) an increase in the real income of capitalists and a decrease in the real
income of landowners.
(c) an increase in the real income of landowners, a decrease in the real income
of capitalists, and an ambiguous effect on the real income of workers.
(d) an increase in the real incomes of landowners and capitalists and an
ambiguous effect on the real income of workers.

6. An increase in the return to land may be the result of:
(a) an increase in the supply of labor.
(b) anincreaseinthepriceoffood.
(c) an increase in the supply of capital.
(d) (a) and (b).
(e) (a) and (c).
7. A reduction of the wage rate may be the result of:
(a) a decrease in the supply of capital.
(b) a decrease in the supply of labor.
(c) a decrease in the price of clothing.
(d) (a) and (b).
(e) (a) and (c).
8. A tariff on clothing will be most strongly opposed by:
(a) landowners.
(b) capitalists.
(c) workers.
9. As more labor is allocated to the clothing industry there is:
(a) increasing returns to labor.
(b) increasing returns to scale.
(c) decreasing returns to scale.
(d) diminishing returns to capital.
(e) diminishing returns to labor.
10. Suppose the home and foreign countries have identical technologies, labor
endowments, and consumer tastes. How would you engineer a comparative
advantage for the home country in clothing production?

11. The unit isoquant illustrates the variety of techniques that can be used to produce a
unit of a given commodity. The diagram below shows the combinations of capital
and labor that are required to produce a unit of x.
(a) Suppose that relative factor prices are given by the slope of line 1. Is it
efficient for the producer to adopt techniques B and C to produce x? Why
or why not?
(b) Now suppose the wage rate in this economy increases and the isocost
curve becomes line 2. How will the producer of x respond to the increase
in the wage rate?
PROBLEMS
1. Production in International Trade:
If a country requires capital and labor to produce clothing, and land and labor to
produce food, and the country has a fixed resource base, explain why the country
is still apt to put some resources into food production, even when it is an exporter
of clothing. In other words, why doesn't this country specialize in its export good?
(Hint: The curvature of the production possibilities frontier has something to do
with this. What determines its shape?)

2. The Determination of Factor Prices in a Small Open Economy:
In each of the cases below, draw in the shift(s) of the appropriate value of the
marginal product of labor curve(s) and determine the change in the wage rate
relative to the price of clothing and the price of food.
(a) A 10% increase in the supply of capital,
(b) A 10% increase in the supply of labor,
(c) A 10% increase in the (absolute) price of food, holding the price of
clothing constant.
3. Changes in the Distribution of Income:
The legislature of a small country engaged in trade is contemplating a tariff on
imports of food that will raise the domestic price of food by 10%. Food
production requires labor and land; clothing production requires labor and capital.
(a) Rank the changes in the returns to land and capital (rT and rK) and labor
(w) relative to the change in the price of food.
(b) Do landlords stand to gain unambiguously from the proposed tariff? Must
capitalists see their returns fall? In each case, explain why or why not.
(c) Suppose that workers, landlords and capitalists all have the same taste
patterns, and that the country imports food. Explain how laborers would
react to the proposal. Who would support a political action committee
(PAC) to enact the tariff?

4. The Four-Quadrant Diagram:
The diagram below is a reproduction of Figure 6.A.1 in the textbook. In drawing
the diagram, it was assumed that capital is the specific factor in the clothing sector,
land is the factor specific to the food sector, and labor is mobile between the
sectors.
(a) Suppose this economy experiences an increase in the supply of capital.
(i) Draw in the shift(s) in the total product of labor curve(s) and the
resulting shift in the production possibilities frontier.
(ii) Assuming homothetic tastes, what happens to the relative price of
clothing?
(iii) What happens to the allocation of labor between the sectors?
(b) Now suppose this economy experiences an increase in the supply of labor
instead of capital.
(i) Draw in the shift in the labor constraint in quadrant III and the
resulting shift in the production possibilities frontier.
(ii) Under the assumption of homothetic tastes, what happens to the
relative price of clothing?
(iii) What happens to the allocation of labor between the sectors?

5. The Netherlands - 1992, and A Little Economic History:
The Netherlands exports agricultural products to and imports manufactured goods
from the rest of the European Union. For the purposes of this problem, assume
that the Netherlands is small relative to the size of the European market. Suppose,
also, that the production of agricultural products requires labor and sector-specific
land, while manufacturing uses labor and sector-specific capital as inputs.
(a) Suppose that, before 1992, the Netherlands had border controls with
effects roughly equivalent to those of a tariff on imports. What would have
been the attitude of Dutch (i) workers, (ii) landowners, and (iii) capitalists
towards the elimination in 1992 of all such controls within the European
Union?
(b) The European Commission announced that migration of labor between
member countries should be unrestricted by 1992. Given that Dutch
workers earned some of the highest wages within the European Union,
what would have been the attitude of Dutch (i) workers, (ii) landowners,
and (iii) capitalists towards an integrated European labor market?
(c) In the past, the Dutch have skillfully conquered land from the sea. As an
economic historian who believes that the specific factors model is the
appropriate model for analyzing the Dutch economy, do you think that the
construction of each new dike was applauded by every citizen of the
Netherlands?
6. Sector-Specific Labor - Reinterpreting the Specific-Factors Model:
Consider an economy with three types of workers: one group of workers with
specialized skills in producing manufactured goods, one group with specialized
skills in making textiles, and another group which can work equally well in both
industries but with no specialized skills in either industry. Define their wages as
wM, wT and wB. In each part, use graphs or equations to support your answer.
(a) Suppose there is an immigration of workers with specialized skills in
producing manufactures. What happens to the production of manufactures?
of textiles?
(b) At unchanged prices of manufactures and textiles, what happens to the
wages of the three groups as a result of this immigration?
(c) Suppose instead there is an increase in immigration of unspecialized
workers. What happens to the production of manufactures and textiles?
(d) What type of immigration policy would specialized workers prefer? If this
model were an accurate description of the U.S. economy, what types of
American workers would be most concerned about the immigration of
unskilled workers into the United States?

7. The Effects of International Trade:
Suppose two countries have the same technologies and tastes. In each country,
land and labor are required to produce food, and capital and labor are required to
produce clothing, but the foreign country is endowed with a greater supply of
arable land. As a result, the autarky price of food relative to clothing is lower in
the foreign country. Now suppose these countries open up to trade.
(a) What happens to the composition of the output bundle in the two countries
relative to the bundles each produced in autarky? Use a diagram of the
production possibilities frontiers in each country to explain your answer.
(b) What happens to the real incomes of workers, landowners and capitalists in
each country as a result of opening up to trade?
(c) We know that some groups will lose in the shift from autarky to free trade.
Do the gainers gain enough to compensate the losers and still be better off
themselves with trade? (Hint: Think about the gains from trade argument
in the simple economy presented in Chapter 3.)
8. The Dutch Disease:
Consider a country that produces oil for export using capital equipment specific to
the oil-drilling industry. The country also produces and exports iron ore, which
requires equipment specific to the mining industry. Labor is mobile. The country
is small relative to the size of the world markets for oil and iron ore, so producers
take world prices for these commodities as given.
(a) Suppose the price of oil increases. What happens to the wage rate of the
mobile labor in this country? How are owners of the two types of
equipment affected?
(c) This country also produces non-traded food for domestic consumption
using land and labor. What happens to the price of food as a result of this
increase in the price of oil?
(c) How is the return to landowners affected? How does this depend on
income and substitution effects in demand?

9. A Production Model With More Than Two Sectors:
Consider a small open economy with mobile labor and four sector-specific types of
capital. The production structure can be depicted as follows:
(a) Suppose the price of good three goes up, while all other prices stay
constant. What happens to:
(i) the wage rate?
(ii) the return to capital in sector three?
(iii) the return to capital in sector one?
(b) What would happen to the wage rate, the return to capital in sector two,
and the return to capital in sector four if foreign capital moved into sector 4
and commodity prices stayed fixed?
Consider the following production structure:

There is no capital, but five types of labor, which are not entirely specific but not
completely mobile either: labor of type A can work in sectors one or two, labor of
type B in sectors two or three, and so forth.
(c) What happens to the wage of labor A and that of labor B if p2 rises?
(Hint: If the wage rate in B goes up what must happen to the wage rate in
C, etc.?)
What happens to the wage of labor C? Labor D?