6-- Case Study- Economic for Strategic decision

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Economic conditions and international trade

MBA 681 Economics for Strategic Decisions Prepared by Yun Wang

Outline 1. Opportunity costs and comparative advantage

2. A one-factor economy, the Ricardian model

3. Gains from trade; Relative wages and trade

4. Empirical evidence

5.The Specific Factors Model

6. International Trade in the Specific Factors Model

7. Income Distribution and the Gains from Trade

Introduction • Differences across countries are a key reason why trade

occurs: – The Ricardian model (Econ/Trade Chapter 3) examines

differences in the productivity of labor (due to differences in technology) between countries.

– The Specific Factors model (Econ/Trade Chapter 4) and the Heckscher-Ohlin model (Econ/Trade Chapter 5) examine differences in labor, labor skills, physical capital, land, or other factors of production between countries.

• Trade may also arise due to economies of scale (larger scale of production is more efficient).

1. The Concept of Comparative Advantage (1 of 6) • The opportunity cost of producing something measures

the cost of not being able to produce something else with the resources used.

• Comparative advantage will be determined by comparing opportunity costs across countries.

The Concept of Comparative Advantage (2 of 6) • A simple example with roses and computers explains the

intuition behind the concepts of opportunity cost and comparative advantage in the Ricardian model.

• For example, suppose a limited number of workers could produce either roses or computers.

– The opportunity cost of producing computers is the amount of roses not produced.

– The opportunity cost of producing roses is the amount of computers not produced.

The Concept of Comparative Advantage (3 of 6) • Suppose that in the United States 10 million roses could be

produced with the same resources as 100,000 computers.

• Suppose that in Colombia 10 million roses could be produced with the same resources as 30,000 computers.

• Colombia has a lower opportunity cost of producing roses: has to stop producing fewer computers in order to free up resources to make a rose.

The Concept of Comparative Advantage (4 of 6) • A country has a comparative advantage in producing

a good if the opportunity cost of producing that good is lower in the country than in other countries.

– The United States has a comparative advantage in computer production.

– Colombia has a comparative advantage in rose production.

The Concept of Comparative Advantage (5 of 6) • Suppose initially that Colombia produces computers

and the United States produces roses, and that both countries want to consume computers and roses.

• Can both countries be made better off?

Table 1 Hypothetical Changes in Production

blank Million Roses Thousand Computers United States −10 +100

Columbia +10 −30

Total 0 +70

The Concept of Comparative Advantage (6 of 6) • When countries specialize in production in which they have

a comparative advantage, more goods and services can be produced and consumed.

– Have the United States stop growing roses and use those resources to make 100,000 computers instead. Have Colombia stop making 30,000 computers and grow roses instead.

– If produce goods in which have a comparative advantage (the United States produces computers and Colombia roses), they could still consume the same 10 million roses, but could consume 100,000 − 30,000 = 70,000 more computers.

2. A One-Factor Economy (1 of 4) • We formalize these ideas by constructing a one-factor

Ricardian model using the following assumptions:

A One-Factor Economy (2 of 4) 1. Labor is the only factor of production. 2. Labor productivity varies across countries due to

differences in technology, but labor productivity in each country is constant.

3. The supply of labor in each country is constant. 4. Two goods: wine and cheese. 5. Competition allows workers to be paid a wage equal to

the value of what they produce, and allows them to work in the industry that pays the highest wage.

6. Two countries: home and foreign.

A One-Factor Economy (3 of 4) • A unit labor requirement indicates the constant number

of hours of labor required to produce one unit of output. – aLC is the unit labor requirement for cheese in the home

country. aLC hours of labor produce one pound of cheese in the home country.

– aLW is the unit labor requirement for wine in the home country. aLW hours of labor produce one gallon of wine in the home country.

• A high unit labor requirement means low labor productivity. – Labor productivity is how much output one hour of

labor creates.

A One-Factor Economy (4 of 4) • Labor supply L indicates the total amount of labor

resources − the number of hours worked (a constant parameter).

• aLC indicates the amount of labor required for each pound of cheese produced (a constant).

• Cheese production QC indicates how many total pounds of cheese that the home country produces.

• aLW indicates the amount of labor required for each gallon of wine produced (a constant).

• Wine production QW indicates how many total gallons of wine that the home country produces.

Production Possibilities (1 of 6) • The production possibility frontier (PPF) of an economy

shows the maximum amount of a goods that can be produced for a fixed amount of resources.

• The production possibility frontier of the home economy is:

aLCQC + aLWQW ≤ L

Production Possibilities (2 of 6) • Maximum home cheese production is C

L Q

a  when 0.wQ 

• Maximum home wine production is w Lw

L Q

a  when 0.cQ 

Production Possibilities (3 of 6) • For example, suppose that the home economy’s labor

supply is 1,000 hours. – aLC = 1 hours/lb, so 1 hour of labor produces one pound

of cheese in the home country. – aLW = 2 hours/gallon, so 2 hours of labor produces one

gallon of wine in the home country.

• The PPF equation aLCQC + aLWQW ≤ L becomes QC + 2QW ≤ 1,000.

• Maximum cheese production is 1,000 pounds.

• Maximum wine production is 500 gallons.

Figure 1 Home’s Production Possibility Frontier

The line PF shows the maximum amount of cheese Home can produce given any production of wine, and vice versa.

Production Possibilities (4 of 6) • The opportunity cost of cheese is how many gallons of

wine Home must stop producing in order to make one more pound of cheese: LC

a a

– The opportunity cost is constant because the unit labor requirements are both constant.

– The opportunity cost of cheese appears as the absolute value of the slope of the PPF.

LC w C

Lw Lw

aL Q Q

a a  

    

Production Possibilities (5 of 6) • Producing an additional pound of cheese requires aLC

hours of labor.

• Each hour devoted to cheese production could have been used instead to produce an amount of wine equal to

1 1 hour/(aLW hours/gallon of wine) gallons of wine

LWa  

    

Production Possibilities (6 of 6) • For example, if 1 hour of labor is moved to cheese

production, that additional hour could have produced

1 1 hour/(2 hours/gallon of wine) gallon of wine.

2  

    

• Opportunity cost of producing one pound of cheese is 1 2

gallon of wine not produced.

Relative Prices and Supply (1 of 7) • PC is the price of cheese; PW is the price of wine.

• wC is the wage paid to workers who make cheese, and wW is the wage paid to workers who make wine.

• Due to competition in the labor and goods markets: – Hourly wages of cheese makers will equal the value of

the cheese produced in an hour: C C

P W

a 

– Hourly wages of wine makers will equal the value of the wine produced in an hour: w

w Lw

P W

a 

Relative Prices and Supply (2 of 7) • Workers will choose to work in the industry that pays the

higher wage. • If the price of cheese relative to the price of wine exceeds

the opportunity cost of producing cheese

,C LC W LW

P a P a



– Then the wage paid when making cheese will exceed the wage in wine

C W C W

LC LW

P P W W

a a   

– So workers will make only cheese (the economy specializes in cheese production).

Relative Prices and Supply (3 of 7) • If the price of cheese relative to the price of wine is less

than the opportunity cost of producing cheese

,C LC W LW

P a P a



– Then the wage in cheese will be less than the wage in wine

C W C W

LC LW

P P W W

a a   

– So workers will make only wine (the economy specializes in wine production).

Relative Prices and Supply (4 of 7) • If the price of cheese relative to the price of wine equals

the opportunity cost of producing cheese

,C LC W LW

P a P a



– Then the wage in cheese will equal the wage in wine

C W C W

LC LW

P P W W

a a   

– So workers will be willing to make both wine and cheese.

Relative Prices and Supply (5 of 7) • For example, suppose cheese sells for PC = $4/pound and

wine sells for PW = $7/gallon. – Wage paid producing cheese is

($4/pound)(1 pound/hour) $4/hour.C LC

P a

 

– Wage paid producing wine is 1

($7/gallon) gallon/hour = $3.50/hour. 2

P a

    

 

– Workers would be willing to make only cheese (the relative price of cheese 4

7 exceeds the opportunity cost

of cheese of 1). 2

Relative Prices and Supply (6 of 7) • If the price of cheese drops to PC = $3/pound:

– Wage paid producing cheese drops to

($3/pound)(1 pound/hour) $3/hour.C LC

P a

 

– Wage paid producing wine is still $3.50/hour if price of wine is still $7/gallon.

– Now workers would be willing to make only wine (the relative price of cheese 3

7 is now less than the

opportunity cost of cheese 1). 2

Relative Prices and Supply (7 of 7) • If the home country wants to consume both wine and cheese (in

the absence of international trade), relative prices must adjust so that wages are equal in the wine and cheese industries.

If C W LC LW

P P a a

– workers will not care whether they work in the

cheese industry or the wine industry, so that production of both goods can occur.

– Production (and consumption) of both goods occurs when the relative price of a good equals the opportunity cost of producing that good:

C LC

W LW

P a P a



Trade in the Ricardian Model (1 of 4) • Use “*” to indicate foreign country variables. • When one country can produce a unit of a good with less

labor than another country, we say that the first country has an absolute advantage in producing that good.

• If aLC < a*LC , Home labor is more efficient than Foreign in producing cheese.

• Does that guarantee that Home should export cheese?

Trade in the Ricardian Model (2 of 4) • Comparative advantage, not absolute advantage,

determines the pattern of trade (more about this distinction later).

• Suppose that the home country has a comparative advantage in cheese production: its opportunity cost of producing cheese is lower than in the foreign country.

* *

LC LC

LW Lw

a a a a



– When the home country increases cheese production, it reduces wine production less than the foreign country would.

Trade in the Ricardian Model (3 of 4) • Since the slope of the PPF indicates the opportunity cost

of cheese in terms of wine, Foreign’s PPF is steeper than Home’s.

– To produce one pound of cheese, must stop producing more gallons of wine in Foreign than in Home.

Figure 2 Foreign’s Production Possibility Frontier

Because Foreign’s relative unit labor requirement in cheese is higher than Home’s (it needs to give up many more units of wine to produce one more unit of cheese), its production possibility frontier is steeper.

Trade in the Ricardian Model (4 of 4) • Before any trade occurs, the relative price of cheese to

wine reflects the opportunity cost of cheese in terms of wine in each country.

• In the absence of any trade, the relative price of cheese to wine will be higher in Foreign than in Home if Foreign has the higher opportunity cost of cheese.

• It will be profitable to ship cheese from Home to Foreign (and wine from Foreign to Home) – where does the relative price of cheese to wine settle?

Determining the Relative Price after Trade (1 of 8) • To see how all countries can benefit from trade, need to

find relative prices when trade exists.

• First calculate the world relative supply of cheese: the quantity of cheese supplied by all countries relative to the quantity of wine supplied by all countries

* *

C C

W W

Q Q RS

Q Q 

 

Determining the Relative Price after Trade (2 of 8) • If the relative price of cheese falls below the opportunity

cost of cheese in both countries

* ,

* C LC LC

W LW Lw

P a a P a a

 

– No cheese would be produced. – Domestic and foreign workers would be willing to

produce only wine (where wage is higher).

Determining the Relative Price after Trade (3 of 8) • When the relative price of cheese equals the opportunity

cost in the home country

* ,

* C LC LC

W LW Lw

P a a P a a

 

– Domestic workers are indifferent about producing wine or cheese (wage when producing wine same as wage when producing cheese).

– Foreign workers produce only wine.

Determining the Relative Price after Trade (4 of 8) • When the relative price of cheese settles strictly in between the

opportunity costs of cheese *

, *

LC C LC

LW W Lw

a P a a P a

 

– Domestic workers produce only cheese (where their wages are higher).

– Foreign workers still produce only wine (where their wages are higher).

– World relative supply of cheese equals Home’s maximum cheese production divided by Foreign’s maximum wine production

. * *

L a L a

Determining the Relative Price after Trade (5 of 8) • When the relative price of cheese equals the opportunity

cost in the foreign country

* ,

* LC C LC

LW W Lw

a P a a P a

 

– Foreign workers are indifferent about producing wine or cheese (wage when producing wine same as wage when producing cheese).

– Domestic workers produce only cheese.

Determining the Relative Price after Trade (6 of 8) • If the relative price of cheese rises above the opportunity

cost of cheese in both countries

* ,

* LC LC C

LW Lw W

a a P a a P

 

– No wine is produced. – Domestic and foreign workers are willing to produce

only cheese (where wage is higher).

Determining the Relative Price after Trade (7 of 8) • World relative supply is a step function:

– First step at relative price of cheese equal to Home’s opportunity cost 1, which equals

2 LC

a a

in the example.

– Jumps when world relative supply of cheese equals Home’s maximum cheese production divided by Foreign’s

maximum wine production , * *

L a L a

which equals 1 in the example.

– Second step at relative price of cheese equal to Foreign’s opportunity cost * ,

* LC

a a

which equals 2 in the example.

Determining the Relative Price after Trade (8 of 8) • Relative demand of cheese is the quantity of cheese

demanded in all countries relative to the quantity of wine demanded in all countries.

• As the price of cheese relative to the price of wine rises, consumers in all countries will tend to purchase less cheese and more wine so that the relative quantity demanded of cheese falls.

Figure 3 World Relative Supply and Demand

The RD and RD’ curves show that the demand for cheese relative to wine is a decreasing function of the price of cheese relative to that of wine, while the RS curve shows that the supply of cheese relative to wine is an increasing function of the same relative price.

3. Gains from Trade (1 of 4) • Gains from trade come from specializing in the type of

production which uses resources most efficiently, and using the income generated from that production to buy the goods and services that countries desire.

– “Using resources most efficiently” means producing a good in which a country has a comparative advantage.

Gains from Trade (2 of 4) • Domestic workers earn a higher income from cheese

production because the relative price of cheese increases with trade.

• Foreign workers earn a higher income from wine production because the relative price of cheese decreases with trade (making cheese cheaper) and the relative price of wine increases with trade.

Gains from Trade (3 of 4) • Think of trade as an indirect method of production that

converts cheese into wine or vice versa.

• Without trade, a country has to allocate resources to produce all of the goods that it wants to consume.

• With trade, a country can specialize its production and exchange for the mix of goods that it wants to consume.

Gains from Trade (4 of 4) • Consumption possibilities expand beyond the production

possibility frontier when trade is allowed.

• With trade, consumption in each country is expanded because world production is expanded when each country specializes in producing the good in which it has a comparative advantage.

Figure 4 Trade Expands Consumption Possibilities

International trade allows Home and Foreign to consume anywhere within the colored lines, which lie outside the countries’ production frontiers.

A Numerical Example (1 of 5)

Unit labor requirements Cheese Wine

Home aLC = 1 hour/lb aLW = 2 hours/gallon

Foreign a*LC = 6 hours/lb a*LW = 3 hours/gallon

• What is the home country’s opportunity cost of producing cheese? 1

, 2

a a

 to produce one pound of cheese, stop producing

1 gallon of wine.

A Numerical Example (2 of 5) • The home country is more efficient in both industries, but

has a comparative advantage only in cheese production.

*1 2

2 * LC LC

LW LW

a a a a

  

• The foreign country is less efficient in both industries, but has a comparative advantage in wine production.

A Numerical Example (3 of 5) • With trade, the equilibrium relative price of cheese to wine

settles between the two opportunity costs of cheese.

• Suppose that the intersection of RS and RD occurs at

1C W

P P

 so one pound of cheese trades for one gallon of wine.

• Trade causes the relative price of cheese to rise in the home country and fall in foreign.

A Numerical Example (4 of 5) • With trade, the foreign country can buy one pound of

cheese for one gallon of wine,C W

P P



– instead of stopping production of *

2 gallons *

a a



of wine to free up enough labor to produce one pound of cheese in the absence of trade.

– Suppose L* = 3,000. The foreign country can trade its 1,000 gallons maximum production of wine for 1,000 pounds of cheese, instead of the 500 pounds of cheese it could produce itself.

A Numerical Example (5 of 5) • With trade, the home country can buy one gallon of wine

for one pound of cheese,W C

P P



– instead of stopping production of 2 poundsLW LC

a a



of cheese to free up enough labor to produce one gallon of wine in the absence of trade.

• The home country can trade its 1,000 pounds maximum production of cheese for 1,000 gallons of wine, instead of the 500 gallons of wine it could produce itself.

Relative Wages (1 of 5) • Relative wages are the wages of the home country

relative to the wages in the foreign country.

• Productivity (technological) differences determine relative wage differences across countries.

• The home wage relative to the foreign wage will settle in between the ratio of how much better Home is at making cheese and how much better it is at making wine compared to Foreign.

• Relative wages cause Home to have a cost advantage in only cheese and Foreign to have a cost advantage in only wine.

Relative Wages (2 of 5) • Suppose that PC = $12/pound and PW = $12/gallon.

• Since domestic workers specialize in cheese production after trade, their hourly wages will be

$12 $12

1 C

P a

 

• Since foreign workers specialize in wine production after trade, their hourly wages will be

$12 $4

* 3 W

P a

 

• The relative wage of domestic workers is therefore $12

3 $4



Relative Wages (3 of 5) • The relative wage lies between the ratio of the productivities

in each industry. – The home country is 6 6

1  times as productive in cheese

production, but only 3 1.5 2  times as productive in wine

production. – The home country has a wage 3 times higher than the

foreign country.

Relative Wages (4 of 5) • These relationships imply that both countries have a cost

advantage in production. – High wages can be offset by high productivity. – Low productivity can be offset by low wages.

• In the home economy, producing one pound of cheese costs $12 (one worker paid $12/hr) but would have cost $24 (six paid $4/hr) in Foreign.

• In the foreign economy, producing one gallon of wine costs $12 (three workers paid $4/hr) but would have cost $24 (two paid $12/hr) in Home.

Relative Wages (5 of 5) • Because foreign workers have a wage that is only

1 3

the wage of domestic workers, they are able to attain a cost advantage in wine production, despite low productivity.

• Because domestic workers have a productivity that is 6 times that of foreign workers in cheese production, they are able to attain a cost advantage in cheese production, despite high wages.

4. Do Wages Reflect Productivity? (1 of 2) • Do relative wages reflect relative productivities of the two

countries?

• Evidence shows that low wages are associated with low productivity.

– Wage of most countries relative to the U.S. is similar to their productivity relative to the U.S.

Productivity and Wages

A country’s wage rate is roughly proportional to the country’s productivity Source: International Monetary Fund and The Conference Board.

Do Wages Reflect Productivity? (2 of 2) • Other evidence shows that wages rise as productivity rises.

– As recently as 1975, wages in South Korea were only 5% of those of the United States.

– As South Korea’s labor productivity rose (to about half of the U.S. level by 2007), so did its wages.

Empirical Evidence (1 of 3) • Do countries export those goods in which their productivity

is relatively high?

• The ratio of U.S. to British exports in 1951 compared to the ratio of U.S. to British labor productivity in 26 manufacturing industries suggests yes.

• At this time the U.S. had an absolute advantage in all 26 industries, yet the ratio of exports was low in the least productive sectors of the U.S.

Figure 5 Productivity and Exports

A comparative study showed that U.S. exports were high relative to British exports in industries in which the United States had high relative labor productivity. Each dot represents a different industry.

Empirical Evidence (2 of 3) • A very poor country like Bangladesh can have comparative

advantage in clothing despite being less productive in clothing than other countries such as China because it is even less productive compared to China in other sectors.

– Productivity (output per worker) in Bangladesh is only 28 percent of China’s on average.

– In apparel, productivity in Bangladesh was about 77 percent of China’s, creating strong comparative advantage in apparel for Bangladesh.

Table 2 Bangladesh versus China, 2011

Blank Bangladeshi Output per Worker as % of China

Bangladeshi exports as a % of China

All industries 28.5 1.0 Apparel 77 15.5

Source: McKinsey and Company, “Bangladesh’s ready-made garments industry: The challenge of growth,” 2012; UN Monthly Bulletin of Statistics.

Empirical Evidence (3 of 3) • The main implications of the Ricardian model are well

supported by empirical evidence: – productivity differences play an important role in

international trade – comparative advantage (not absolute advantage)

matters for trade

5. The Specific Factors Model (1 of 4) • The specific factors model allows trade to affect income

distribution.

• Assumptions of the model: – Two goods, cloth and food. – Three factors of production: labor (L), capital (K) and

land (T for terrain). – Perfect competition prevails in all markets.

The Specific Factors Model (2 of 4) – Cloth produced using capital and labor (but not land). – Food produced using land and labor (but not capital). – Labor is a mobile factor that can move between sectors. – Land and capital are both specific factors used only in

the production of one good.

The Specific Factors Model (3 of 4) • How much of each good does the economy produce? • The production function for cloth gives the quantity of cloth

that can be produced given any input of capital and labor:

 ,C C CQ Q K L – QC is the output of cloth – K is the capital stock – LC is the labor force employed in cloth

The Specific Factors Model (4 of 4) • The production function for food gives the quantity of food

that can be produced given any input of land and labor:

  ,F F FQ Q T L – QF is the output of food – T is the supply of land – LF is the labor force employed in food

Production Possibilities (1 of 6) • How does the economy’s mix of output change as labor is

shifted from one sector to the other?

• When labor moves from food to cloth, food production falls while output of cloth rises.

• Figure 4.1 illustrates the production function for cloth.

Figure 6 The Production Function for Cloth

The more labor employed in the production of cloth, the larger the output. As a result of diminishing returns, however, each successive person-hour increases output by less than the previous one; this is shown by the fact that the curve relating labor input to output gets flatter at higher levels of employment.

Production Possibilities (2 of 6) • The shape of the production function reflects the law of

diminishing marginal returns. – Adding one worker to the production process (without

increasing the amount of capital) means that each worker has less capital to work with.

– Therefore, each additional unit of labor adds less output than the last.

• Figure 4.2 shows the marginal product of labor, which is the increase in output that corresponds to an extra unit of labor.

Figure 7 The Marginal Product of Labor

The marginal product of labor in the cloth sector, equal to the slope of the production function shown in Figure 4.1, is lower the more labor the sector employs.

Production Possibilities (3 of 6) • For the economy as a whole, the total labor employed in

cloth and food must equal the total labor supply:

 C FL L L

• Use these equations to derive the production possibilities frontier of the economy.

Production Possibilities (4 of 6) • Use a four-quadrant diagram to construct production

possibilities frontier in Figure 4.3. – Lower left quadrant indicates the allocation of labor. – Lower right quadrant shows the production function for

cloth from Figure 4.1. – Upper left quadrant shows the corresponding

production function for food. – Upper right quadrant indicates the combinations of

cloth and food that can be produced.

Figure 8 The Production Possibility Frontier in the Specific Factors Model

PP in the upper-right quadrant shows the economy’s production possibilities for given supplies of land, labor, and capital. Due to diminishing returns, PP is a bowed-out curve instead of a straight line.

Production Possibilities (5 of 6) • Why is the production possibilities frontier curved?

– Diminishing returns to labor in each sector cause the opportunity cost to rise when an economy produces more of a good.

– Opportunity cost of cloth in terms of food is the slope of the production possibilities frontier – the slope becomes steeper as an economy produces more cloth.

Production Possibilities (6 of 6) • Opportunity cost of producing one more yard of cloth is

MPL MPL

pounds of food.

– To produce one more yard of cloth, you need 1

CMPLhours of labor. – To free up one hour of labor, you must reduce output of

food by FMPL pounds.

– To produce less food and more cloth, employ less in food and more in cloth.

– The marginal product of labor in food rises and the marginal product of labor in cloth falls, so F

MPL MPL

rises.

Prices, Wages, and Labor Allocation (1 of 10)

• How much labor is employed in each sector? – Need to look at supply and demand in the labor

market.

• Demand for labor: – In each sector, employers will maximize profits by

demanding labor up to the point where the value produced by an additional hour equals the marginal cost of employing a worker for that hour.

Prices, Wages, and Labor Allocation (2 of 10) • The demand curve for labor in the cloth sector:

 C CMPL P W

– The wage equals the value of the marginal product of labor in manufacturing.

• The demand curve for labor in the food sector:

 F FMPL P W – The wage equals the value of the marginal product of

labor in food.

Prices, Wages, and Labor Allocation (3 of 10) • Figure 4.4 represents labor demand in the two sectors.

• The demand for labor in the cloth sector is MPLC from Figure 4.2 multiplied by PC

• The demand for labor in the food sector is measured from the right.

• The horizontal axis represents the total labor supply L.

Prices, Wages, and Labor Allocation (4 of 10) • The two sectors must pay the same wage because labor

can move between sectors.

• If the wage were higher in the cloth sector, workers would move from making food to making cloth until the wages become equal.

– Or if the wage were higher in the food sector, workers would move in the other direction.

• Where the labor demand curves intersect gives the equilibrium wage and allocation of labor between the two sectors.

Figure 9 The Allocation of Labor

Labor is allocated so that the value of its marginal product (P × MPL) is the same in the cloth and food sectors. In equilibrium, the wage rate is equal to the value of labor’s marginal product.

Prices, Wages, and Labor Allocation (5 of 10) • At the production point, the production possibility frontier

must be tangent to a line whose slope is minus the price of cloth divided by that of food.

• Relationship between relative prices and output:

   CF C F

PMPL MPL P

Figure 10 Production in the Specific Factors Model

The economy produces at the point on its production possibility frontier (PP) where the slope of that frontier equals minus the relative price of cloth.

Prices, Wages, and Labor Allocation (6 of 10) • What happens to the allocation of labor and the distribution

of income when the prices of food and cloth change?

• Two cases: 1. An equal proportional change in prices 2. A change in relative prices

Prices, Wages, and Labor Allocation (7 of 10) • When both prices change in the same proportion, no real

changes occur. – The wage rate (w) rises in the same proportion as the

prices, so real wages (i.e., the ratios of the wage rate to the prices of goods) are unaffected.

– The real incomes of capital owners and landowners also remain the same.

Figure 11 An Equal-Proportional Increase in the Prices of Cloth and Food

The labor demand curves in cloth and food both shift up in proportion to the rise in PC from 1 2toC CP P and the rise in PF

1 2from to .F FP P The wage rate rises in the same proportion, 1 2from to ,W W but the allocation of labor between the two

sectors does not change.

Prices, Wages, and Labor Allocation (8 of 10) • When only PC rises, labor shifts from the food sector to the

cloth sector and the output of cloth rises while that of food falls.

• The wage rate (w) does not rise as much as PC since cloth employment increases and thus the marginal product of labor in that sector falls.

Figure 12 A Rise in the Price of Cloth

The cloth labor demand curve rises in proportion to the 7 percent increase in PC, but the wage rate rises less than proportionately. Labor moves from the food sector to the cloth sector. Output of cloth rises; output of food falls.

Figure 13 The Response of Output to a Change in the Relative Price of Cloth

The economy always produces at the point on its production possibility frontier (PP) where the slope of PP equals minus the relative price of cloth. Thus, an increase in C FP P causes production to move down and to the right along the production possibility frontier corresponding to higher output of cloth and lower output of food.

Figure 14 Determination of Relative Prices

In the specific factors model, a higher relative price of cloth will lead to an increase in the output of cloth relative to that of food. Thus, the relative supply curve RS is upward sloping. Equilibrium relative quantities and prices are determined by the intersection of RS with the relative demand curve RD.

Prices, Wages, and Labor Allocation (9 of 10) • Relative Prices and the Distribution of Income

– Suppose that PC increases by 10%. Then, the wage would rise by less than 10%.

• What is the economic effect of this price increase on the incomes of the following three groups?

– Workers, owners of capital, and owners of land

Prices, Wages, and Labor Allocation (10 of 10) • Owners of capital are definitely better off.

• Landowners are definitely worse off.

• Workers: cannot say whether workers are better or worse off:

– Depends on the relative importance of cloth and food in workers’ consumption.

6. International Trade in the Specific Factors Model (1 of 3) • Trade and Relative Prices

– The relative price of cloth prior to trade is determined by the intersection of the economy’s relative supply of cloth and its relative demand.

– Free trade relative price of cloth is determined by the intersection of world relative supply of cloth and world relative demand.

– Opening up to trade increases the relative price of cloth in an economy whose relative supply of cloth is larger than for the world as a whole.

Figure 15 Trade and Relative Prices

The figure shows the relative supply curve for the specific factors economy along with the world relative supply curve. The differences between the two relative supply curves can be due to either technology or resource differences across countries. There are no differences in relative demand across countries. Opening up to trade induces an increase in the relative price from     1 2to .C F C FP P P P

International Trade in the Specific Factors Model (2 of 3) • Gains from trade

– Without trade, the economy’s output of a good must equal its consumption.

– International trade allows the mix of cloth and food consumed to differ from the mix produced.

– The country cannot spend more than it earns:

  C C F F C C F FP D P D P Q P Q

International Trade in the Specific Factors Model (3 of 3) • The economy as a whole gains from trade.

– It imports an amount of food equal to the relative price of cloth times the amount of cloth exported:

   

      

C F F C C

P D Q Q D

– It is able to afford amounts of cloth and food that the country is not able to produce itself.

– The budget constraint with trade lies above the production possibilities frontier in Figure 4.11.

7. Figure 16 Budget Constraint for a Trading Economy and Gains from Trade Point 2 represents the economy’s production. The economy can choose its consumption point along its budget constraint (a line that passes through point 2 and has a slope equal to minus the relative price of cloth). Before trade, the economy must consume what it produces, such as point 1 on the production possibility frontier (PP). The portion of the budget constraint in the colored region consists of feasible post-trade consumption choices, with consumption of both goods higher than at pretrade point 1.