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Chapter 3 Specific Factors and Income Distribution. Kernel of the Chapter. The Specific Factors Model International Trade in the Specific Factors Model Income Distribution and the Gains from Trade The Political Economy of Trade: A Preliminary View. The Specific Factors Model. - PowerPoint PPT Presentation
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Chapter 3Specific Factors and Income Distribution
2
The Specific Factors Model International Trade in the Specific Factors Model Income Distribution and the Gains from Trade The Political Economy of Trade: A Preliminary View
Kernel of the Chapter
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Assumptions of the Model• One economy that can produce two goods, manufactures and
food.
• three factors of production; labor (L), capital (K) and land (T for terrain).
• Manufactures are produced using capital and labor (but not land).
• Food is produced using land and labor (but not capital).
– Labor is therefore a mobile factor
– Land and capital are both specific factors.
• Perfect Competition prevails in all markets.
The Specific Factors Model
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• The production function for good X gives the maximum quantities of good X that a firm can produce with various amounts of factor inputs.
– For instance, the production function for manufactures (food) tells us the quantity of manufactures (food) that can be produced given any input of labor and capital (land).
The Specific Factors Model
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• The production function for manufactures is given by QM = QM (K, LM) (3-1)
• The production function for food is given by
QF = QF (T, LF) (3-2)
The Specific Factors Model
• The full employment of labor conditionLM + LF = L (3-3)
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Production Possibilities• To analyze the economy’s production possibilities, we
need only to ask how the economy’s mix of output changes as labor is shifted from one sector to the other.
• Figure 3-1 illustrates the production function for manufactures.
The Specific Factors Model
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QM = QM (K, LM)
Figure 3-1: The Production Function for Manufactures
The Specific Factors Model
Labor input, LM
Output, QM
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• The shape of the production function reflects the law of diminishing marginal returns.
• Figure 3-2 shows the marginal product of labor, which is the increase in output that corresponds to an extra unit of labor.
The Specific Factors Model
9
MPLM
Figure 3-2: The Marginal Product of Labor
The Specific Factors Model
Labor input, LM
Marginal product of labor, MPLM
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QF =QF(K, LF)
QM =QM(K, LM)
L2M
L2F
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1
L
LAA
1'
3'
PP
Economy’s production possibility frontier (PP)
Production functionfor manufacturesEconomy’s allocation
of labor (AA)
Production functionfor food
Q2F
Q2M
2'
Labor input in food, LF (increasing )
Output of manufactures, QM (increasing )
Labor input in manufactures, LM (increasing )
Output of food, QF (increasing )
Figure 3-3: The Production Possibility Frontier in the Specific Factors Model
The Specific Factors Model
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Prices, Wages, and Labor Allocation• How much labor will be employed in each sector?
• Demand for labor:
The Specific Factors Model
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• The demand curve for labor in the manufacturing sector can be written:
MPLM x PM = w (3-4)
• The demand curve for labor in the food sector can be written:
MPLF x PF = w
(3-5)
The Specific Factors Model
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The wage rate must be the same in both sectors, because of the assumption that labor is freely mobile between sectors.
The wage rate is determined by the requirement that total labor demand equal total labor supply:
LM + LF = L (3-6)
The Specific Factors Model
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PM X MPLM
(Demand curve for labor in manufacturing)
PF X MPLF
(Demand curve for labor in food)
Wage rate, W Wage rate, W
W1
1
L1M L1
F
Total labor supply, L
Labor used in manufactures, LM
Labor used in food, LF
Figure 3-4: The Allocation of Labor
The Specific Factors Model
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At the production point
-MPLF/MPLM = -PM/PF (3-7)
The Specific Factors Model
Slope = -(PM /PF)1
1Q1
F
Q1M
Output of manufactures, QM
Output of food, QF
PP
Figure 3-5: Production in the Specific Factors Model
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• What happens to the allocation of labor and the distribution of income when the prices of food and manufactures change?
• Two cases:– An equal proportional change in prices
– A change in relative prices
The Specific Factors Model
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W1 1
PF increases 10%
Wage rate, WWage rate, W
PF 1 X MPLF
Labor used in manufactures, LM
Labor used in food, LF
10% wage increase
PM increases 10%
PM 1 X MPLM
W2
2
PF 2 X MPLFPM 2 X MPLM
Figure 3-6: An Equal Proportional Increase in the Prices of Manufactures and Food
The Specific Factors Model
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• When both prices change in the same proportion, no real changes occur.
– The real incomes of capital owners and landowners also remain the same.
The Specific Factors Model
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• When only PM rises, the wage rate (w) does not rise as much as PM since manufacturing employment increases and thus the marginal product of labor in that sector falls.
The Specific Factors Model
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PF 1 X MPLF
Wage rate, WWage rate, W
PM 1 X MPLM
2W 2
Labor used in food, LF
Labor used in manufactures, LM Amount of labor
shifted from food to manufactures
Wage rate rises by less than 7%
7% upward shift in labor demand
PM 2 X MPLM1
W 1
Figure 3-7: A Rise in the Price of Manufactures
The Specific Factors Model
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PP
Slope = - (PM /PF)1
Output of manufactures, QM
Output of food, QF
Slope = - (PM /PF) 2
1Q1
F
Q1M
2Q2
F
Q2M
Figure 3-8: The Response of Output to a Change in the Relative Price of Manufactures
The Specific Factors Model
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Relative quantityof manufactures, QM/QF
Relative price of manufactures, PM /PF
RD
RS
Figure 3-9: Determination of Relative Prices
1 (PM /PF )1
(QM /QF )1
The Specific Factors Model
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Relative Prices and the Distribution of Income
• Suppose that PM increases by 10%. Then, we would expect the wage to rise by less than 10%, say by 5%.
• What is the economic effect of this price increase on the incomes of the following three groups?
– Workers
– Owners of capital
– Owners of land
The Specific Factors Model
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• Workers:– We cannot say whether workers are better or worse off;.
• Owners of capital:– They are definitely better off.
• Landowners:– They are definitely worse off.
The Specific Factors Model
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Assumptions of the model• Assume that both countries (Japan and America) with
the same relative demand.
• The only source of international trade is the differences in relative supply which arises from the difference in:
– Technology
– Factors of production (capital, land, labor)
International Trade in the Specific Factors Model
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Resources and Relative Supply• What are the effects of an increase in the supply of
capital stock on the outputs of manufactures and food?
International Trade in the Specific Factors Model
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PM X MPLM2
PF 1 X MPLF
Wage rate, WWage rate, W
PM X MPLM1
W 1
1
2W 2
Increase in capital stock, K
Amount of labor shifted from food to
manufactures
Labor used in manufactures, LM
Labor usedin food, LF
International Trade in the Specific Factors Model
Figure 3-10: Changing the Capital Stock
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• An increase in the supply of capital would shift the relative supply curve to the right.
• An increase in the supply of land would shift the relative supply curve to the left.
• The effect of an increase in the labor force? – The effect on relative output is ambiguous, although
both outputs increase.
International Trade in the Specific Factors Model
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Trade and Relative Prices• Suppose that Japan has more capital per worker than
America, while America has more land per worker than Japan.
• International trade leads to a convergence of relative prices.
International Trade in the Specific Factors Model
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Relative quantity of manufactures, QM/QF
Relative price of manufactures, PM /PF
(PM /PF )W
(PM /PF )A
(PM /PF )J
International Trade in the Specific Factors Model
Figure 3-11: Trade and Relative Prices
RDWORLD
RSA
RSWORLD
RSJ
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The Pattern of Trade• In a country that cannot trade, the output of a good
must equal its consumption.
• International trade makes it possible for the mix of manufactures and food consumed to differ from the mix produced.
• A country cannot spend more than it earns.
International Trade in the Specific Factors Model
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Budget constraint (slope = -PM/PF)
Consumption of manufactures, DM
Output of manufactures, QM
Consumption of food, DF
Output of food, QF
Production possibility curve
International Trade in the Specific Factors ModelFigure 3-12: The Budget Constraint for a Trading Economy
Q1M
1Q1
F
33
QJF
QAF
DAFDJ
F
QAM DA
MQJMDJ
M
Japan’s food
imports
America’s food
exports
Japan’s manufactures
exports
America’s manufactures
imports
Quantity of manufactures
Quantity of manufactures
Quantity of food
Quantity of food
Japanese budget constraint American budget constraint
International Trade in the Specific Factors Model
Figure 3-13: Trading Equilibrium
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Income Distribution and the Gains from Trade
To assess the effects of trade on particular groups, the key point is that international trade shifts the relative price of manufactures and food.
Trade benefits the factor that is specific to the export sector of each country, but hurts the factor that is specific to the import-competing sectors.
Trade has ambiguous effects on mobile factors.
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Could those who gain from trade compensate those who lose, and still be better off themselves?
The fundamental reason why trade potentially benefits a country is that it expands the economy’s choices.• This expansion makes it possible to redistribute
income in such a way that everyone gains from trade.
Income Distribution and the Gains from Trade
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Budget constraint(slope = - PM/PF)
PP
Consumption of manufactures, DM
Output of manufactures, QM
Consumption of food, DF
Output of food, QF
Q1M
Q1F
12
Figure 3-14: Trade Expands the Economy’s Consumption Possibilities
Income Distribution and the Gains from Trade
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Trade often produces losers as well as winners. Optimal Trade Policy
• The government must somehow weigh one person’s gain against another person’s loss.
• Any realistic understanding of how trade policy is determined must look at the actual motivations of policy.
The Political Economy of Trade: A Preliminary View
38
Income Distribution and Trade Politics• Those who gain from trade are a much less
concentrated, informed, and organized group than those who lose.
– Example: Consumers and producers in the U.S. sugar industry
The Political Economy of Trade: A Preliminary View