Unformatted text preview: Chapter 4: Part 3 Relationship between goods prices and factor prices Factor price equalization Stopler Samuelson Theorem: if the relative price of a good increases, this will raise the real return of the factor that is used intensively in the production of that good, and will lower the real return of the other good Income distribution and income inequality: the effects of trade Empirical evidence of H0 Model 1 Factor Prices and Goods Prices Under perfect competition, the price of a good equals the cost of production (zero profit) PCQC=wLC+rTC PFQF=wLF+rTF Cost of production depends on the wage rate and the rental rate of land (factor prices). 2 Factor Prices and Goods Prices The effect of an increase in the rental rate of land on the price of cloth depends on the intensity of land usage in cloth production. An increase in the rental rate of land will affect the price of food more than the price of cloth. Under competition, changes in w/r are therefore directly related to changes in PC /PF . 3 Factor Prices and Goods Prices If w/r increases, expect that PC /PF must increase as well because the costs of making cloth relative to food should increase. If w/r decreases, expect that PC /PF must decrease as well because the costs of making cloth relative to food should decrease. 4 Factor Prices and Goods Prices Alternatively, if PC /PF increases, we know that the cloth industry will expand and the food industry will contract. This should increase the relative demand for labor to land bidding up w/r in factor markets. If PC /PF increases, w/r increases If PC /PF decreases, w/r decreases
5 Factor Prices and Goods Prices 6 Factor Prices and Goods Prices We have a relationship between relative factor prices and relative goods prices. StolperSamuelson theorem goes farther: if the relative price of a good increases, then the real wage or real rate of return of the factor used intensively in the production of that good increases, while the real wage or real rate of return of the other factor decreases. (will not formally prove this in this class) 7 StoplerSamuelson Theorem: If cloth is labor intensive and food land intensive, then Factor Prices and Goods Prices If PC /PF increases, raise income of workers relative to that of landowners, w/r. w/ PC w/PF increases, (real income of workers increases) r/ PC and r/PF decreases, (real income of landowners decreases) If PC /PF decreases, lowers income of workers relative to that of landowners, w/r. w/ PC and w/PF decreases 8 r/ PC and r/PF increases Factor Prices, Goods Prices and Factor Levels 9 Factor Prices and Goods Prices We have a theory that predicts changes in the distribution of income when the relative price of goods changes, say because of trade. Due to trade, we should see that the relative price of the good that is intensive in the country's abundant factor rises. This should increase the real payment of the abundant factor and lower the real payment of the other factor. Example: A rise in the price of cloth raises the purchasing power of domestic laborers and lowers the purchasing power of domestic landowners. The model predicts that owners of abundant factors gain but owners of scarce factors lose from trade.
10 Factor Price Equalization Unlike the Ricardian model, the Heckscher Ohlin model predicts that factor prices will (under certain conditions) be equalized among countries that trade. This means that w=w* and r=r* 11 Factor Price Equalization If the domestic country is labor abundant relative to the foreign country, in autarky the domestic country should have a lower price of labor than the foreign country. If the domestic country starts exporting cloth, a labor intensive good, this is an indirect way of the domestic country's becoming a net exporter of labor. This depresses wages in the foreign country and increase them in the domestic country such that wages start to converge.
12 Factor Price Equalization Within a country, trade increases the demand for goods produced by abundant factors (relative to autarky), this indirectly increases the demand for the abundant factors themselves, raising the factor prices of the abundant factors across countries. This consequently raises the price of abundant factors and lowers the price of scarce factors and causes factor prices to converge. If there is enough trade, factor prices will fully converge.
13 Factor Price Equalization If both countries are diversified after trade, and if the technologies are the same across countries, then the costs of production are the same and FPE will be achieved. Because relative prices are equalized and because of the direct relationship between relative prices and factor prices, factor prices are also supposed to be equalized. 14 Factor Price Equalization
Proof of FPE for nonsubstitutable inputs: Suppose both countries produce both goods under trade. Then we know that zero profit holds in both countries and both industries and that prices of output are the same across countries. 15 Factor Price Equalization
(1) PC=aLCw+aTCr and (2) PC=aLCw*+aTCr* (3) PF=aLFw+aTFr and (4) PF=aLFw*+aTFr* (1) and (2) imply aLCw+aTCr =aLCw*+aTCr* or (5) (ww*)=aTC/aLC (r*r) (3) and (4) imply that (6) (ww*)=aTF/aLF (r*r) (5) And (6) imply that aTC/aLC (r*r) =aTF/aLF (r*r) The only way this can be true is if r=r* and w=w*.
16 Factor Price Equalization HO Model predicts factor price equalization (FPE) FPE implies ie that wages of skilled labor should be the same as wages in skilled labor across 2 trading countries that wages of unskilled labor should be the same as wages in unskilled labor across 2 trading countries that prices of capital machinery, land etc should be the same across two trading countries But factor prices are not really equal across countries. 17 1. Reasons for nonFPE The model predicts that trading countries produce the same goods, so that prices and unit costs for those goods can equalize, but countries may produce different sets of goods. When countries are diversified, it means that the costs of production have equalized across countries. When countries remain specialized in certain goods, there is no guarantee that unit costs have converged (ie no guarantee that factor prices have fully converged). Trade in goods is an indirect way of trading factors of production. If countries are very different, there may not be enough trade to generate full convergence of factor prices and consequently convergence in the costs of production. In this case countries remain specialized. 18 Factor Price Equalization Factor Price Equalization
2. The model assumes that trading countries have the same technology, but different technologies could affect the productivities of factors and therefore the wage rates paid to these factors. Factor payment =Marginal Product of the factor * Price of Output If productivities differ, factor payments may differ 19 Factor Price Equalization
3. Trade barriers and transportation costs may prevent goods' prices and factor prices from equalizing. Tariffs and transportation costs drive wedges in prices across countries. 20 4. Specific factors: Factors may not be fully mobile across sectors in the short run. After an economy liberalizes trade, factors of production may not quickly move to the industries that intensively use abundant factors. In the short run, the productivity of factors will be determined by their use in their current industry, so that their return may vary across countries. Example: In the domestic country, with trade the food industry contracts. If workers and land in the food industry are not able to find immediate employment in the expanding cloth sector, then both workers and landowners in the food industry may be worse off for a time.
21 Factor Price Equalization Does Trade Increase Income Inequality between Skilled and Unskilled Workers? Over the last 40 years, countries like South Korea, Mexico and China have exported to the US goods intensive in unskilled labor (e.g., clothing, shoes, toys, assembled goods). At the same time, income inequality has increased in the US, as wages of unskilled workers have grown slowly compared to those of skilled workers. (wU/wS has decreased or wS/wU has increased in the US)
22 Did the former trend cause the latter trend? Does Trade Increase Income Inequality between Skilled and Unskilled Workers?
Did increased trade between the US and LDC's increase the US skill premium? The HeckscherOhlin model predicts that owners of abundant factors will gain from trade and owners of scarce factors will lose from trade. HO Model predicts that through trade wS/wU should increase in the US and fall in unskilled abundant countries. But little evidence supporting this prediction exists.
23 US: Skilled abundant China/Mexico: Unskilled abundant Does Trade Increase Income Inequality between Skilled and Unskilled Workers?
1. According to the model, a change in income distribution occurs through changes in goods prices, but there is no evidence of a change in the prices of skillintensive goods (PS) relative to prices of unskilledintensive goods (PU). For example: in the US we should see PS/PU increasing, and this, by way of the StoplerSamuelson Theorem, should increase wS/wU . However, we do not see that the price of skilled intensive goods relative to unskilled intensive goods has risen drastically in the US.
24 Does Trade Increase Income Inequality between Skilled and Unskilled Workers?
1. According to the model, wages of unskilled workers should increase in unskilled labor abundant countries relative to wages of skilled labor, but in some cases the reverse has occurred: Wages of skilled labor have increased more rapidly in Mexico than wages of unskilled labor. 2. Even if the model were exactly correct, trade is a small fraction of the US economy, so its effects on US prices and wages prices should be small. 25 Does Trade Increase Income Inequality between Skilled and Unskilled Workers?
Skilled Biased Technological Change Economists put most of the blame of the rising skill premium in the US and other countries on skilled biased technological change Skill biased technological change is a change in the technology of producing goods that raises the productivity of skilled workers relative to unskilled workers wS =MPS* Price of Output WU=MPU*Price of Output wS/wU =MPS/MPU 26 Does Trade Increase Income Inequality between Skilled and Unskilled Workers?
Skilled Biased Technological Change
Therefore, if the relative productivity of skilled workers increased, this would lead to an increase in the skilled premium. This would also explain why we see rising skill premiums across countries, even unskilled abundant ones.
27 Trade and Income Distribution: Political Economy of Trade Policy
Should we oppose trade liberalization to protect the losers from trade? On the one hand, trade may not be the culprit (skill biased technological change and trade is a small part of US GDP) Changes in income distribution occur with every economic change, not only international trade. Changes in technology, changes in consumer preferences, exhaustion of resources and discovery of new ones all affect income distribution. 28 Trade and Income Distribution: Political Economy of Trade Policy It would be better to compensate the losers from trade (or any economic change) than prohibit trade. The economy as a whole does benefit from trade. More goods and services are available, so technically it is theoretically possible to make all people strictly better off. It would be better to facilitate labor mobility across sectors from contracting to expanding sectors Could use a redistribution program like TAA to compensate the losers and retrain to find jobs in expanding sectors 29 Trade and Income Distribution: Political Economy of Trade Policy Potential Policy Backlash of Protectionism? If the economy experiences overall gains why does protectionism get so much attention? There is a political bias in trade politics: potential losers from trade are better politically organized than the winners from trade. Losses are usually concentrated among a few, but gains are usually dispersed among many. Each of you pays about $8/year to restrict imports of sugar, and the total cost of this policy is about $2 billion/year. The benefits of this program total about $1 billion, but this amount goes to relatively few sugar producers.
30 Empirical Evidence of the HeckscherOhlin Model Factor Content Studies Try to estimate the factor content of imports and exports (ie the units of capital and labor embodied in trade) See if the predicted trade in factors matches the HO prediction 31 For example: Suppose there are only two types of goods: a capital intensive good (machinery) and a labor intensive good (textiles). aKM/aLM > aKT/aLT Empirical Evidence of the HeckscherOhlin Model HO Theory predicts that the capital abundant country should export machinery and import textiles The capital to labor ratio embodied in the capital abundant country's exports (E) are: The capital to labor ratio embodied in the capital abundant country's imports (M) are : Therefore, the capital to labor ratio in this country's exports should exceed the capital to labor ratio in the country's imports according to the HO model. aKTMT/(aLTMT) = aKT/aLT aKMEM/(aLMEM)= aKM/aLM 32 Empirical Evidence of the HeckscherOhlin Model Similarly, if capital abundant countries truly export capital intensive goods and import labor intensive goods then we expect that for these countries... Capital to labor embodied in exports> capital to labor embodied in imports 33 Empirical Evidence of the HeckscherOhlin Model Tests on US data Leontief did a study on the US and found that the US was the the most capitalabundant country in the world The HO model suggests that if the US is capital abundant, it should have a larger ratio of capital to labor in its exports versus in its imports. But Leontief found that US exports were less capitalintensive than US imports: Leontief paradox.
34 Empirical Evidence of the HeckscherOhlin Model 35 Empirical Evidence of the HeckscherOhlin Model
Tests on global data Bowen, Leamer, and Sveikauskas tested the Heckscher Ohlin model on data from 27 countries and 12 factors of production and confirmed the Leontief paradox on an international level. HO model suggests countries should be net exporters of abundant factors and net importers of scarce factors. Made predictions about what the HO model suggested for 27 countries and 12 factors For each factor calculated the percent of countries that had trade patterns consistent with the HO model. For 2/3 of the data, the predictive success was less than 50%no better than a coin toss.
36 Empirical Evidence of the HeckscherOhlin Model 37 Empirical Evidence of the HeckscherOhlin Model Tests on manufacturing data between very low and very high income countries This data lends more support to the theory. 38 Empirical Evidence of the HeckscherOhlin Model 39 Summary
1. Substitution of factors in the production process generates a curved PPF. When an economy produces a low level of a good, the opportunity cost of producing that good is low. When an economy produces a high level of a good, the opportunity cost of producing that good is high. When an economy produces on its PPF, the opportunity cost of producing a good equals the relative price of that good. 2. 40 Summary 1. 2. If the relative price of a good increases, then the real wage or rate of return of the factor used intensively in the production of that good increases, while the real wage or rate of return of the other factor decreases. If we hold output prices constant as a factor of production increases, then the supply of the good that uses this factor intensively increases, and the supply of the other good decreases.
1. An economy will export goods that are intensive in its abundant factors of production and import goods that are intensive in its scarce factors of production. The HeckscherOhlin model predicts that relative output prices and factor prices will equalize, neither of which occurs in the real world. The model predicts that owners of abundant factors gain, but owners of scarce factors lose with trade. 2. 3. 42 Summary 1. 2. A country as a whole will be better off with trade, even though the model predicts that owners of scarce factors will be worse off without compensation. Empirical support of the HeckscherOhlin model is weak except for cases involving trade between high income countries and low/middle income countries. 43 ...
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