Lecture 3a:

Specific-factor Model

Thibault FALLY
C181 – International Trade
Spring 2018
• CHAPTER 2: Ricardian model:
• Only one factor of production: labor
• Labor is mobile across sectors
 Everyone gains from trade

The next model relaxes these assumptions:

• CHAPTER 3: But what if:

• We have more than one factor of production?
• What if these factors are NOT mobile across sectors?
 Then there may be losers and winners!
(unequal effects of globalization)
• CHAPTER 3: Road map:

• Setting up the specific factor model

• Change in production and employment

• Aggregate gains from trade

• Effect on labor wages

• Effect on returns to K and Land

1 Setup of Factor-Specific Model
Setup
• Two countries: Home and Foreign.
• Two sectors: Manufacturing and Agriculture

• Manufacturing uses labor and capital

• Agriculture uses labor and land.
1 Setup of Factor-Specific Model
Setup
• Two countries: Home and Foreign.
• Two sectors: Manufacturing and Agriculture

• Manufacturing uses labor and capital

• Agriculture uses labor and land.

• Diminishing returns for labor in each industry:

The marginal product of labor declines if the
amount of labor used in the industry increases.
1 Setup of Factor-Specific Model
Alternative interpretation

NOTE:
We can also use the same model and interpret “capital”
and “land” as fixed labor:

Capital: equivalent to Labor that is stuck in manufacturing

Land: equivalent to Labor that is stuck in Agriculture
Labor: Labor that is mobile across industries

 Three types of labor depending on its mobility

(for the lecture, we’ll keep talking about capital and land as it’s easier to follow)
1 Setup of Factor-Specific Model
Production function with Constant Returns to Scale:
• Manufacturing output: Y  F ( K , L)

such that: F (K , L)  F ( K , L)

1 Setup of Factor-Specific Model
Production function with Constant Returns to Scale:
• Manufacturing output: Y  F ( K , L)

such that: F (K , L)  F ( K , L)

• This implies decreasing returns to scale if we focus

on one input:
F ( K , L)  F (K , L)
 F ( K , L )  F ( K , L )

MPL
• In each industry: 0
L
1 Setup of Factor-Specific Model
Diminishing returns for labor in each industry:

(same for Agriculture: MPL decreases with production)

1 Setup of Factor-Specific Model
Example of production function:
YM  aM K 1/ 3 LM
2/3
• Manufactures:

• Agriculture: YA  a AT
1/ 3 2/3
LA
 1 Setup of Factor-Specific Model
Example of production function:
YM  aM K 1/ 3 LM
2/3
• Manufactures:

• Agriculture: YA  a AT
1/ 3 2/3
LA

 Marginal product of Labor:

aM K LM 
2
• MPL in Manufactures: MPLM 
1/ 3

• MPL in Agriculture: MPLA  a A T LA 

2 1/ 3

3
 1 Setup of Factor-Specific Model
Example of production function:
YM  aM K 1/ 3 LM
2/3
• Manufactures:

• Agriculture: YA  a AT
1/ 3 2/3
LA

 Marginal product of Labor:

• MPL in Manufactures: MPL M 

2
a M  K LM 1/ 3

3
Increases with K LM

• MPL in Agriculture: MPLA  a A T LA 1/ 3

2
Increases with T LA
3
 1 Setup of Factor-Specific Model
Example of production function:
YM  aM K 1/ 3 LM
2/3
• Manufactures:

• Agriculture: YA  a AT
1/ 3 2/3
LA

 Marginal product of Capital and Land:

• MPK in Manufactures: MPK  aM LM K 2 / 3

1
3

• MPT in Agriculture: MPT  a A LA T 2 / 3

1
3
 1 Setup of Factor-Specific Model
Example of production function:
YM  aM K 1/ 3 LM
2/3
• Manufactures:

• Agriculture: YA  a AT
1/ 3 2/3
LA

 Marginal product of Capital and Land:

• MPK in Manufactures: MPK  aM LM K 2 / 3

1
Decreases with K L
3
M

• MPT in Agriculture: MPT  a A LA T 2 / 3

1
Decreases with T LA
3
 Production Possibility Frontier:
A) How does it look like
B)
in this case?

D)
C)
 Production Possibility Frontier:
A) How does it look like
B)
in this case?

D)
C)
Slope of PPF reflects the opportunity cost of manuf. output:

If one worker moves from A to B

(i.e. from Ag to Manufacturing):
Change in QA = - MPLA
Change in QM = + MPLM

PPF
Slope of PPF reflects the opportunity cost of manuf. output:

If one worker moves from A to B

(i.e. from Ag to Manufacturing):
Why does the slope increase?

PPF
Slope of PPF reflects the opportunity cost of manuf. output:

If one worker moves from A to B:

Why does the slope increase?
MPLA increases and MPLM decreases

PPF
1 Setup of Factor-Specific Model
Slope of PPF
Why does the slope increase from point A to B?

• Slope equals MPLA/MPLM

• As LA decreases, MPLA increases

• As LM increases, MPLM decreases

 Hence the ratio increases!

1 Setup of Factor-Specific Model
Labor market and relative prices
• Labor is mobile across sectors
• Hence wages are equalized:

W  PM  MPLM
W  PA  MPL A
• And should be the same across sectors. Hence:

PM MPL A

PA MPLM
= Slope of the PPF
1 Setup of Factor-Specific Model
Equilibrium in Autarky:

Autarky Equilibrium:
tangency between PPF and
indifference curve
1 Setup of Factor-Specific Model
Equilibrium in Autarky:

Autarky Equilibrium:
tangency between PPF and
indifference curve

In contrast to Ricardian model,

preferences affect equilibrium
relative price!
• CHAPTER 3: Road map:

• Setting up the specific factor model

 Change in production and employment

• Aggregate gains from trade

• Effect on labor wages

• Effect on returns to K and Land

2 Effect of Trade on production
The Foreign Country
• Let us assume that Home has a comparative advantage
in manufacturing

 Equivalent to assuming that the Home no-trade relative

price of manufacturing is lower than Foreign rel. price:
(PM /PA) < (P*M /P*A).

New world price?

2 Effect of Trade on production
The Foreign Country
• Let us assume that Home has a comparative advantage
in manufacturing

 Equivalent to assuming that the Home no-trade relative

price of manufacturing is lower than Foreign rel. price:
(PM /PA) < (P*M /P*A).

New world price:

(PM /PA) < (PM /PA)W < (P*M /P*A).

Effect on production?
2 Effect of Trade on production

New relative price

2 Effect of Trade on production

New relative price

New production mix

2 Effect of Trade on production
Quantitative example:
In the next example with Cobb-Douglas production,
I would like to show you:

• How to link ratio of MPL to employment

• How to link ratio of MPL to prices

 How to link employment to prices

2 Effect of Trade on production
Quantitative example:
YM  aM K 1/ 3 LM
2/3
• Manufactures:

• Agriculture: YA  a AT
1/ 3 2/3
LA
Marginal product of Labor:

• MPL in Manufactures: MPLM  aM K LM 

2 1/ 3

3
• MPL in Agriculture: MPLA  a A T LA 1/ 3
2
3
2 Effect of Trade on production
Quantitative example:
YM  aM K 1/ 3 LM
2/3
• Manufactures:

• Agriculture: YA  a AT
1/ 3 2/3
LA
Marginal product of Labor:

• MPL in Manufactures: MPLM  aM K LM 

2 1/ 3

3
• MPL in Agriculture: MPLA  a A T LA 1/ 3
2
3
1/ 3
MPL A a AT 1/ 3
 LM 
 Slope of PPF: Slope   1/ 3
 
MPLM aM K  LA 
2 Effect of Trade on production

Quantitative example:
1/ 3
MPL A a AT 1/ 3
 LM 
• Slope of PPF: Slope    
MPLM aM K 1 / 3  LA 

Constant term x Employment ratio

2 Effect of Trade on production

Quantitative example:
1/ 3
MPL A a AT 1/ 3
 LM 
• Slope of PPF: Slope   
1/ 3 

MPLM aM K  LA 
PM
• At equilibrium: Slope 
PA
LA
• How does a change in prices affects LM?
2 Effect of Trade on production

Quantitative example:
1/ 3
MPL A a AT  LM 1/ 3

• Slope of PPF: Slope   
1/ 3 

MPLM aM K  LA 
PM
• At equilibrium: Slope 
PA
LA
• How does a change in prices affects LM?
1/ 3 3
PM a AT 1/ 3
 LM  LA a T  PA 
3
     A
 
PA aM K 1 / 3  LA 
3
LM a K  PM 
M
Clicker question:
If the relative price of manufacturing goods increases
by 1%, relative employment in manufacturing LM LA
increases by:

a) A negative percentage, i.e. decreases!!

b) Increases by 1%

c) Increases by 0.33%

d) Increases by 3%
Answer:
Answer:
If the relative price of manufacturing goods increases
by 1%, relative employment in manufacturing LM LA
increases by:

d) Increases by 3%
Some useful algebra…

Quantifying changes with exponents, etc.:


• Suppose Z a X
• If X increases by 1% then Z increases by β %.

• If Z increases by 1% then X increases by 1/β %.

• Suppose Z  X .Y
• If X increases by x %
• If Y increases by y %

 Then Z increases by: x+y %.

• CHAPTER 3: Road map:

• Setting up the specific factor model

• Change in production and employment

 Aggregate gains from trade

• Effect on labor wages

• Effect on returns to K and Land

3 Gains from Trade

Overall Gains from Trade?

• We start by looking at the average consumer

3 Gains from Trade

Supply side:

New relative price

New production mix

3 Gains from Trade
Demand side:
New equilibrium consumption

New budget line

 Clicker Q:
Trade for the
50 Home country is…?

30

15

0
25 30 40

a) XM = 5, MA = 20; b) XM = 20, MA = 20;

c) XM = 15, MA = 35; d) XM = 20, MA = 15;
3 Gains from Trade
Overall Gains from Trade

So far, things are not very different from Ricardo:

New world price:

(PM /PA) < (PM /PA)W < (P*M /P*A).

• Manufacturing goods are exported,

• Agricultural goods are imported
• For an average consumer, Home is better off with trade.
3 Gains from Trade
Gains for everyone?

• When there are gains from trade on average, it does not

imply that everyone gains from trade

• The interesting part of the model is to examine what

happens to the return to each factor:
1) Labor wage
2) Rental rate of Capital and Land

Do workers gain? Do land and capital owner gain?

• CHAPTER 3 – Next lecture (part 2):

• Setting up the specific factor model

• Change in production and employment

• Aggregate gains from trade

 Effect on labor wages?

 Effect on returns to Capital and Land?