CFJ6 - TRADE AND LOCAL INCOME DISTRIBUTION THE SPECIFIC...

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Unformatted text preview: TRADE AND LOCAL INCOME DISTRIBUTION: THE SPECIFIC FACTORS MODEL eliance on the one—factor Ricardian model serves to hide the reasons for the strong internal disagreements within a nation that often accompany trade policies. Adding land and capital rounds out the classical trilogy and helps to reveal how changes in the terms of trade create real gains for some income groups and real losses for others. In this chapter we begin by assuming that to pro— duce foodstuffs the economy must combine labor with land, while to produce clothing the services of capital must be combined with labor. Land and capital are thus treated as factors specific to a particular sector. Later we reinterpret the set— ting so that the specific factors represent different kinds of capital (or, perhaps, dif- ferent kinds of labor). Factor specificity then becomes a short-run phenomenon that may be overcome with the passage Of time. DIMINISHING RETURNS AND FACTOR HIREs One of the earliest concepts encountered in the study of economics is that of dimm— z'sloz'ng returns. As more and more of a variable factor is added in the production process to given amounts of a specific factor, what happens to total output pro— duced? It increases. But the incremental output is not maintained—it falls as more of the variable input is added to a fixed factor. This is a property Of production that is perfectly consistent with our assumption that technology exhibits constant re- turns to scale, that increasing all inputs in proportion results in output going up by the same proportion. Consider the food sector, now assumed to employ both labor and land. Suppose the quantity Of land is fixed, and ask how total food output varies as more and more labor is employed in this sector. Food output rises at an ever—decreasing rate. This law of diminishing returns implies that the marginal product of labor in food falls as more and more labor is added to a fixed supply Of land. How much labor would be hired by a competitive firm facing both a given price at which food can be sold in the market and a given wage rate at which labor can be hired? Deflate the wage, to, by the price of food, p . This shows how much a laborer must be paid, not in dollars, but in food units. If labor’s marginal physical product were greater than this amount, the firm would do well to hire more labor. If, in- stead, the firm has hired so much labor that an additional unit would raise food out— put by less than must be paid for the hire, the firm has overshot the mark—it should 92 CHAPTER 6 TRADE AND LOCAL lNCOME DISTRIBUTION: THE SPECIFIC FACTORS MODEL 6.2 reduce employment until the deflated wage is equal to labor’s marginal physical product. This is the familiar argument for factor hires in competitive markets. Technology that exhibits constant returns to scale also allows uniform changes in factor and commodity prices. By this is meant that if the wage rate and rental that must be paid on land should both rise by the same percentage amount, so would the unit cost of production and, in a competitive market, the market price. But this implies an important relationship among prices: Iffactor prices change, the percentage change in the commodity price must lie between the percentage changes in factor returns. The rationale is simple. Suppose the wage rate rises by 10 percent and the rental on land by 20 percent. Unit costs must rise by at least 10 percent, which would be the exact outcome if the rental had risen by 10 percent instead of 20 per— cent, but cannot rise by more than 20 percent, which would be the exact result if wages had risen by 20 percent. In competitive markets, prices reflect unit costs, so that the percentage price change must be trapped between the percentage changes in wages and rents. Similar remarks can be made for the clothing sector, except we now assume that the fixed factor is capital. All revenue earned in the clothing sector will, in competitive markets, either be represented in the wage bill or’will be captured as rents to owners of capital equipment. OUTPUTS AND INCOME DISTRIBUTIONzTHE CLOSED ECONOMY Figure 6.1 illustrates that the economy’s production—possibilities schedule no longer has the straight—line shape of the Ricardian model. The reason? Diminishing returns. Consider the movement from point N to N ’. The only way inlwhich cloth— ing output can be expanded is by releasing labor from the food sector and putting it to work with capital to produce clothing. But such a transfer alters the marginal ' productivity of labor in both sectors—in opposite directions. Adding more labor g to a fixed quantity of capital in the clothing sector does cause output to increase, V but at a diminishing rate. The marginal product Of labor in clothing at point N’ is smaller than it is at point N. In the food sector the departure of labor serves to in— I; crease labor’s marginal product in producing food because there is now more land - used per unit of labor at N' than at N. The slope of the bowed—out transformation schedule in Figure 6.1 is equal to (minus) the ratio of labor’s marginal product in the two sectors. The reasoning is simple: The drop in food output in going from N to N’ is (roughly) equal to la— _ bor’s marginal product in producing food times the quantity Of labor lost to the clothing sector. The increase in clothing output is equal to labor’s marginal prod- _ uct in producing clothing times the extra labor hired. Since the amount Of labor r leaving the food sector equals the amount added to clothing production, our asser— tion is proved: The slope of the transformation schedule equals (minus) labor’s marginal product in food divided by its marginal product in producing clothing. Figure 6.I Production Possibilities with Increasing Opportunity Costs The closed economy equilibrium is at N.The transformation curve is bowed out, reflecting the law of diminishing returns. 6.3 6.3 THE DISTRIBUTION OF INCOME WITH FREE TRADE 93 Food Clothing And such a ratio rises as more clothing is produced. The closed—economy equilib— rium point (N) is located at the point where indifference curve, yo, is tangent to the transformation schedule. The common slope at N reflects the relative price of clothing. Turn now to a different but extremely useful diagram—one that highlights the role of commodity prices and factor supplies in helping to determine labor’s mar— ginal productivities and thus the wage rate. This is Figure 6.2. Since relative prices are What count, fiX the price of food at some arbitrary level and let the VMPf curve (the curve showing the value of the additional output of food produced by one more laborer) decline as more labor is added to the food sector, measuring rightward from origin OF in Figure 6.2. The value of labor’s marginal product is the given price of food times labor’s marginal physical product. A similar schedule can be drawn for the value of labor’s marginal product in producing clothing. Figure 6.2 depicts such a VMPIIJC schedule reading from right to left from origin 0C. It is possible to bring these curves together as shown because the total labor supply (the horizontal distance separating 0F from 0C) is fixed and is fully employed. Equilibrium labor allocation is at point G. Height A in Figure 6.2 depicts the equi— librium wage rate. Each of the specific factors, land and capital, receives the total revenue in the sector that employs that factor, over and above the wage payment. THE DISTRIBUTION OF INCOME WITH FREE TRADE When this economy is opened up to trade, which factors of production benefit? Which lose? Is it possible to identify each group unambiguously? We make use of Figures 6.1 and 6.2 in tracing, step by step, the impact on an economy initially in 94 CHAPTER 6 TRADE AND LOCAL INCOME DISTRIBUTION: THE SPECIFIC FACTORS MODEL Figure 6.2 ' Wage Wage Wage Rate Determination rate C ’rate Equilibrium wages (at A) equate ‘* (VMPL ) the values of the marginal product of labor in the two sectors by la- bor allocation at G. If free trade raises clothing’s price, labor shifts out of food into clothing (from G to G’).The wage rate rises, but not as much as clothing’s price. .. VMPL 0F ——I> LF G G LC<——— 00 <—--——————- Total labor supply ———-—-—--—-——-> autarky. Suppose clothing is relatively expensive on world markets, so that output responds as shown by the movement from N to N’ in Figure 6.1—-—clothing output expands. In Figure 6.2 we have illustrated this country’s emergence into the world market by (arbitrarily) keeping the price of food (and thus the VMPf schedule) constant and raising the price of clothing. If clothing’s price is, say, 40 percent higher in world markets, the VMPE schedule shifts upward by exactly 40 percent. The reason: Any given labor input into clothing (e.g., at an initial level of OCG) and the fixed background quantity of capital yield the same marginal physical product of labor, but a price increase of 40 percent implies a 40 percent higher marginal value product of labor. If, in response to the price changes brought about by free trade, labor could not be reallocated between sectors, a 40 percent wage gap (DE) would be created in Figure 6.2. But such a gap serves as a signal to attract labor to clothing and out of the food sector. This process of reallocation alters marginal productivities in each sector, until allocation point G’ is reached with the new wage rate G’B, repre— senting an increase in nominal wages. How do landlords, capitalists, and laborers react to the move to free trade? 1. Owners of capital are delighted by the new prices. As workers move into the cloth— ing sector, the marginal physical product of capital rises. Add to this the price rise for clothing (40 percent), and the return to capital is twice blessed—wit rises by more than 40 percent. 2. Landlords are at the other end of scale. Stuck in the food sector, whose relative price is now lower, they are forced by the market to pay more for labor as workers 6.4 6.4 GROWTH IN FACTOR ENDOWMENTS 95 decamp for the clothing sector. Thus, less labor is available per unit of land and the marginal physical product of land falls. The consequence: Land rentals fall relative to the price of food, and even more so compared with the higher price of clothing. Landlords unambiguously lose. Their self—interest would be served by opposing free trade. The fate of laborers is less extreme. As just seen, the land/labor ratio used to pro— duce food rises as labor leaves the agricultural sector, so that wages rise in terms of food. But the price of clothing has increased more than the wage rate. In Figure 6.2 the price of clothing has risen by 40 percent, the ratio DE/EG. Wages have risen in the move from E to B, but by less than 40 percent. This confirms point 1 above, that the return to capitalists rises by more than 40 percent, and point 2 above, that landlords’ returns fall, relative to the given price of food, since nominal wages have gone up. In each industry the price (and unit cost) change must be flanked by the relative changes in factor rewards for inputs used in that sector. The preceding arguments show that changes in commodity prices have an un— even impact on the incomes of various categories of productive factors. The factors of production (labor in this model) that have opportunities for employment in all sectors of the economy and are highly mobile may find their real position not significantly altered by changes in the terms of trade. However, specific factors (land and capital in this model) are severely affected. Specific factors used only in the industries suffering from a fall in relative price have no other outlet for em- ployment. Their low mobility ensures that real returns fall. By contrast, the specific factors in the favored industry (owners of capital in the clothing industry) find their returns unambiguously raised. They are sheltered from increased competition from similar factors in other industries (no textile machines are available in the food industry) and benefit from the arrival of newly attracted other factors (labor) that serve to raise productivity. ‘ Any government policy (for example, a tariff change) that serves to affect rela— tive commodity prices will be viewed differently by various factor groups. Factors used only in the favored sector would strongly support the proposed measure. Factors used only in the rest of the economy would unambiguously lose. In the model there is a third category—factors (such as labor) that are not affected much one way or the other by such a policy. This is why political scientists find such a model useful in explaining why some sectors of the population do not bother vot— ing on certain issues whereas others care deeply. Very few policies that impact pri~ marily on relative commodity prices can be expected to gain widespread approval. GROWTH IN FACTOR ENDOWMENTS A nation’s resource base need not remain static. Over time, one can expect the capi— tal stock to rise, and perhaps more (or less) land to be brought into productive use. Population may grow, but this might be offset by shortening the work week or, in 96 CHAPTER 6 TRADE AND LOCAL INCOME DISTRIBUTION: THE SPECIFIC FACTORS MODEL the opposite direction, by increased participation of both spouses in the market— place. As well, foreign investment could encourage capital accumulation or immi— gration might expand supplies of labor. How do such changes alter production choices and factor returns in an economy too small to have these supply changes affect world prices? First, let us suppose that growth is confined to one of the specific factors. To be precise, consider for this small trading community the consequence of a 50 per— cent increase in the quantity of land available. The primary impact of such a change is to increase labor’s productivity in producing food. At constant commod— ity prices this will entail a reallocation of labor resources and will bring in its wake a change in all factor returns and an outward shift in the community’s production possibilities curve. Figure 6.3 reproduces the initial equilibrium at E shown in Figure 6.2. Whereas the commodity price rise shown in Figure 6.2 depicts the value of labor’s marginal product curve shifting upwards by a given percentage amount, a rise of 50 percent in the quantity of land available would be illustrated in Figure 6.3 by a rightward shift of 50 percent in the schedule showing the value of labor’s marginal product in producing food. The reasoning behind this shift is based on the as— sumption that returns to scale are constant, and that commodity prices are being kept fixed. Therefore, if the quantity of labor is increased 50 percent when the land supply is raised 50 percent, the marginal product (and value of the marginal product} of labor would remain unchanged; a 50 percent increase in both labor and land raises output by exactly 50 percent, but leaves marginal physical prod— ucts the same. Such a shift encourages labor to move out of clothing into food, and the equilibrium value of the wage rate is pushed upwards to point B in Figure 6.3. Notice that with labor being the only mobile productive factor, the output of food has risen (but by less than 50 percent, since the increase in the wage rate has low- ered the labor/land ratio utilized in producing food), and the output of clothing has fallen (since this sector loses labor). The new transformation schedule lies fur— ther from the origin than the original one (except at the point where it comes out of the clothing axis). Furthermore, the output changes described above as taking place when commodity prices are constant confirm that the point on the new transformation schedule that has the same slope as the former schedule at the orig— inal equilibrium lies northwest of that equilibrium. Comparable changes occur if the capital supply should grow by 50 percent, with total land and labor supplies constant. The production possibilities schedule shifts out such that at constant commodity prices (and thus at a given slope for the transformation schedule) larger quantities of clothing are produced, with a smaller output in the food sector. Labor growth at constant commodity prices leads to a more balanced expan— sion of both outputs. The base in Figure 6.2 or Figure 6.3 would have to be enlarged. Keep the VMPf schedule anchored to the OP origin, and the VMPE sched— ule anchored to the 0C origin. Thus, an increase in the labor force would slide these schedules farther apart, serving to decrease the equilibrium wage rate. Each sector would respond by hiring more labor at the lower wage; outputs in both sectors would rise. Figure 6.3 An Increase in Land An increase Of 50% in land shifts the VMPf schedule rightward by 50% to (VMPf)’, and raises the wage rate. 6.5 6.5 POLITICAL ECONOMYASPECTS 97 Wage rate 0F T" LF Lc+ 0 4—————————-— Labor supply ——-———-—-——> C These factor supply changes have an effect on wages and rentals paid to each of the specific factors. An increase in either land or capital supply favors wages; the wage increase in turn serves to reduce returns to both specific factors. An in— crease in the labor supply, by contrast, depresses the wage rate, and works to the benefit of both specific factors. POLITICAL ECONOMY ASPECTS These remarks, coupled with the analysis of terms—of—trade changes, lead to the following generalizations. If commodity prices remain constant but factor endowments change, the fortunes of the specific factors (land and capital) rise or fall together and are opposed to those of the mobile factor (labor). If endowments remain constant but commodity—price ratios change, the returns to the specific factors are driven widely apart, Whereas the return to mobile labor is relatively unaffected. If the relative price of clothing rises, capitalists unambigu— ously gain and landlords lose. These are important properties of this model, which will be used in subsequent policy discussions. Consider here some basic political considerations. The first gen— erality suggests a natural political alliance between landlords and capitalists in small, but growing, communities immersed in a trading world. One would expect a mutual interest of landlords and capitalists in legislation designed to encourage immigration of labor, whereas workers already in the country might oppose immi— 98 CHAPTER 6 TRADE AND LOCAL INCOME DISTRIBUTION: THE SPECIFIC FACTORS MODEL 6.6 largely because of pressure from unions. In Australia, more liberal immigration policy is supported both by capitalists and by landholders, although trade unions find it in their interests to control such inflows. As Europe boomed in the decades after World War II, the American labor movement was often outspoken in its criti— cism of US. capital flows lured by burgeoning European markets. The second generality suggests that if the legislation under consideration con- cerns relative commodity prices, landlords and capitalists would be diametrically opposed. A classic historical example concerns the Corn Laws in nineteenth—cen- tury Britain. Parliamentary overrepresentation Of the landed gentry allowed laws that prevented the importation of cheap grains. After 1832 and the Reform Bill, parliamentary representation of industrialists (and labor) expanded. By 1846 the movement to freer trade was in full swing. The interests Of capitalists were clear. Lower food prices would drive workers off the land and serve to lower the indus— trial wage, thus leading to greater profits.1 A twentieth—century analogy is found in present~day Japan, which has been highly restrictive in its tolerance of agricultural imports. (Japanese rice is over four times as expensive as that found in the world market.) The United States, ever anxious to improve its bilateral trade balance with Japan, has loudly denounced these agricultural trade restrictions. But, per- haps, American manufacturers who compete with Japanese exporters would not be pleased if restrictions were loosened, and thus allowed workers in Japan to re— ceive nominal pay cuts while enjoying higher real wages as food prices fall. Larger agricultural imports into Japan could also lead to greater Japanese exports of man~ ufactures. Japanese landlords and industrialists are at Odds over these trade restric- tions, and, as in the case of nineteenth—century Britain, major changes may require political reforms to dilute the power of rural areas. THE PATTERN OF TRADE In some respects, the pattern of trade in this setting should be easy to predict. Countries with relatively large amounts of land will export food; countries with relatively large amounts Of capital will export clothing. The close identification of these two factors, land and capital, with unique outputs, food and clothing, makes obvious the logic whereby production patterns are linked to the underlying factor , endowment comparison between countries. The setting that we shall examine in I the following chapter is less obvious, since there each factor is utilized at least to _ some extent in both industries. Nonetheless, the bias imparted to production pat- terns emanating from inter—country differences in supplies of productive factors will still prevail. However, other features of demand and supply also have a bear- ing on the equilibrium pattern of trade: Tastes. Even if the home country has a relatively large supply of capital and thus a bias to produce relatively large quantities of clothing if home and foreign countries face a common set of commodity prices with free trade, differences in tastes could affect the trade pattern. In particular, a strong taste bias for clothing at home cOuld 1The wage would not fall as much as the price of food. 6.7 6.7 ALTERNATIVE lNTERPRETATIONS: SPECIFIC CAPITAL OR LABOR 99 result in the home country being a relatively expensive source of clothing, so that with trade it imports this item. Technology. The Ricardian model of Chapter 5 emphasized the role of differences in technology in dictating patterns of trade. The concepts of relative demand and relative supply, as illustrated in Figure 3.5, are appropriate in showing how differ- ences in endowments or technology play a role in determining trade patterns. In that situation, the foreign relative supply curve for food, which lies to the right of the home relative supply curve, could reflect an underlying, higher relative endow— ment of land compared with capital in the foreign country. Or, it might be the case that foreign food technology is relatively superior; points A and A ’* illustrate that for comparable relative output proportions the relative cost of producing food is lower abroad. Endowment differences and technology differences may reinforce each other. Alternatively, they could push costs in opposite directions. Finally, we have yet to comment on the consequences of one country having a relatively large labor force. Does this bias the likely pattern of trade? The answer to this question is more subtle. We have already shown that an expansion of the la— bor force shifts the production possibilities schedule outward, such that at the same terms of trade, more of both commodities will be produced. Whether the ra— tio of their production is altered, however, depends on the manner in which food and clothing technologies differ, both in the intensity with which they require labor and the elasticity of their demand for labor. Details are banished to the supplement to this chapter. ALTERNATIVE INTERPRETATIONS: SPECIFIC CAPITAL OR LABOR So far our discussion has portrayed labor as completely mobile between sectors, with capital only used to produce clothing and land an input only in the food sector. But we can depart from this classical trilogy of land, labor, and capital, and suppose that land is an insignificant input into production. This frees us up to consider two alternative interpretations of this simple model. ‘ In the first interpretation, suppose that two different types of capital are used in production—say textile capital in clothing and tractors in production of food, with labor still mobile between these two sectors. In considering the effect of world price changes on income distribution and outputs for a small open economy, contrast the results now with those we discussed in Chapter 5 ’s Ricardian model. If the relative price of clothing rises in world markets, labor is drawn to this sector from the food industry. The wage rate rises in terms of food, but falls in terms of textiles—the kind of intermediate result we found for mobile labor in Figure 6.2. The return to each kind of capital is much different in the two sectors: The rental on textile machinery rises by more than any price, and the return to. tractors used to produce food falls. These rents on capital serve as shock absorbers, as seen by the comparison with a Ricardian labor—only model. In the latter case, suppose ini— tially the economy produces both goods before the price of clothing rises. After the price rise the food sector would be completely wiped out, unable to compete at the Tu. LLA a u A n A a 5 A A HA AL -...,._A,. u- “A--. "MAJ «mm. “A.-.” M- -.-A-:£:_ --.-:r_1- -lun..l- IOO CHAPTER 6 TRADE AND LOCAL INCOME DISTRIBUTION: THE SPECIFIC FACTORS MODEL 6.8 the price shocks so that some food production can still take place. This comment proves relevant to the next section’s discussion of the “Dutch disease.” Trade and Unskilled Wage Rates Consider, now, an alternative scenariowone in which all capital is completely mo- bile between sectors (e.g., computers), but labor is no longer homogeneous. Suppose some part of the labor force has “skills,” while the remainder is unskilled. To nail things down, suppose skilled labor is used to produce clothing and un— skilled labor to produce foodmwith homogeneous and mobile capital used in both sectors. Furthermore, suppose clothing is this country’s export industry and that changes in world prices take place such that the price of clothing rises and food’s price remains constant. What is the consequence for local income distribution? The real return to capital does not change very much, but the fate of skilled and unskilled labor is vastly different. The real wage for skilled workers rises, while that for the unskilled falls. This scenario, whereby changing prices on world mar— kets cause grief for a country’s unskilled labor force but not for skilled workers, is often invoked in describing the fate of labor in the United States in the past two decades. Of course, other factors may play a key role, such as changes in technol— ogy which favor the use of skilled workers relative to the unskilled. In both of these alternatives there is a time dimension suggested, since specific capital does wear out and new capital can take different forms. That is, specificity may be a short—run state of affairs, while in the long run capital is in effect mobile between sectors. As well, with time unskilled labor may be able to acquire skills . through education or experience, so that specificity here is also a short—run phe— nomenon. Chapter 7 builds on this theme. THE DUTCH DISEASE The energy crises of the 19703, the early 1980s, and the late 1990s, along with the associated increases in the prices of some world—traded products and resources, have led to radical internal stresses in the economic sectors producing commodi- ties whose world prices have not Changed much. In Europe this kind of phenome— non came to be called the Dutch disease. The name referred specifically to the rapid development in the Netherlands of the sector producing natural gas and the resulting squeeze put on other traditional export sectors of the Dutch economy. Similarly, in Norway and Great Britain rapid exploitation of North Sea oil de— posits created severe hardships for manufacturing sectors that competed in world markets. Much less disruption was brought about in the sectors servicing purely local markets—the non—traded sector.2 2An analytic treatment of some aspects of this issue is found in W. M. Corden and]. Peter Neary, “Booming Sector and De—lndustrialization in a Small Open Economy,” Economic journal (December 1982): 825—848. 6.8 THE DUTCH DiSEASE NH The simple model developed in this chapter can be utilized to reveal strategic features of this phenomenon. Suppose a number of industries are producing for the world market. In each one of these labor is drawn from a common pool (labor is the mobile factor) and combined with another factor specific to that sector and in fixed supply. Let each sector have its own supply of capital equipment (and man— agerial expertise) that is uniquely designed for usetin that sector. Suppose the world price of the output in one of these sectors rises. As already outlined, the main features of the food~clothing model generalize readily to this multisector case.3 In particular, returns to factors specifically used in the favored (booming) traded sector rise by more than price. More crucially, the wage rate is bid up, and this increase in wages squeezes all the other traded sectors that have not experi— enced a rise in price. In Chapter 5’s Ricardian model with fixed labor coefficients, a wage rise would cause the complete collapse of any traded sector facing fixed world prices. Here the industry may survive, but only as long as lower returns are accepted by specific factors. Higher wage rates triggered by the rise in price in the booming sector put the squeeze on profits (or returns to specific capital and man— agement) in any other traded sector. Figure 6.4 illustrates the case of the Dutch disease. A typical, traditional ex— port sector facing a constant price, P, on world markets has an upward-sloping supply curve, S, as increases in output are achieved by combining more labor with a fixed quantity of capital. The presumed boom in another export sector pushes up the wage rate and, through this connection, affects costs throughout the rest of the economy. For this traditional export sector the supply curve shifts up to S’, the re— turns to the specific factor are squeezed, and output is lowered from GA to 0D if the sector does not benefit from a rise in price. Figure 6.4 Price in traditional The “Dutch Disease” export sector A boom in a new export sector raises wages, which shifts costs up- ward for a traditional export sector. Returns to capital are squeezed and output fails. Output 3Formal extensions are found in R. W. Tones. “income, Distribution and Effectier Prnter‘tinn in a [02 CHAPTER 6 TRADE AND LOCAL lNCOME DISTRlBUTION: THE SPECIFIC FACTORS MODEL 6.9 The Fate of the Non-Traded Sector The discussion of the Ricardian model concluded with the introduction of the con— cept of a non—traded sector, an industry producing a commodity that can be nei- ther exported nor imported because of high costs of transport. Suppose such a sector is added here. When one export sector expands, pushing up wage rates, the non-traded sector also experiences a rise in costs. However, for non—traded goods the price to consumers can be raised. If there were no shift in demand, these cost increases could be partially passed on to consumers, with output reduced. To alle— Viate the situation further for non—tradeables, the demand curve may shift to the right. With an export boom caused by a price rise, the community’s real income expands with the favorable movement in the terms of trade. This will partly spill over to increased demand in the non—tradeable sector. in addition, local demand might increase as a consequence of a direct substitution effect away from the ex- portable that has risen in price toward other markets. Much the same story can be told if, instead of a price rise in one traded goods sector, there is technical progress (as illustrated in Chapter 5 for the Ricardian model), or there are new discoveries (such as North Sea oil). The role of the doctrine of comparative advantage is crucial in understanding the phenomenon of the Dutch disease. A country exports commodities in which it possesses a comparative advantage. It may lose such an advantage in some com— modities even if the technology in that sector is unchanged, if in other sectors its technology (or price) improves. In the present model the route through which tra- ditional sectors get squeezed is a rise in the wage rate. Although the model is not explicitly geared to handle the phenomenon at this stage, another avenue through which traditional traded sectors can be affected is the exchange rate. British manu- facturers of commodities enjoying an export market were hit at the end of the 1970s by a strengthening of the British pound, caused in part by anticipation of future oil revenues from North Sea discoveries. These same discoveries caused con— cern in Norway that wages might rise and threaten the competitive position of other Norwegian industries. SUMMARY This chapter presents one of the classic models of production—a model in which diminishing returns describe the attempt of any sector to increase output by apply— ing more labor to a fixed quantity of another factor specific to that sector. ‘ Commodities differ in their factor demands, clothing makes no use of land and food does not require capital; and factors of production differ in their degree of mobility, labor is costlessly transferable from sector to sector at a common wage, whereas land and capital are each specific. This description of an economy is rich in its conclusions for a community en— gaged in trade. The internal distribution of income is vitally affected by any change in relative commodity prices. A productive factor specifically tied to some occupation (e.g., land in the production of food) unambiguously gains by an increase in the relative 6.9 SUMMARY |03 price of the commodity in whose production it is employed. This price rise will cause other specific factors to lose in real terms. This feature of the model, by it— self, predicts that any political decision within a community that threatens to affect commodity prices (such as tariff legislation) will arouse ardent support on the part of some and strong opposition from others, as well as fairly widespread apathy from groups not vitally affected. The mobile factor is less affected by commodity price changes because it can move from sector to sector. This discrepancy in inter- ests can be read in the historical record of almost any significant move concerning trade. Changes in trade policy are apt to prove divisive, and this chapter shows the lines of division running along the characteristics that distinguish, one productive factor from another. Income distribution is also affected by growth. Not surprisingly, greater supplies of a factor tend to depress its return. If commodity prices are largely determined by world markets, there is a natural alliance among specific factors (landlords and capitalists) to raise their own returns by encouraging immigration of nonspecific labor. The composition of outputs is quite sensitive to changes in a community’s underly— ing factor endowment base. This is especially true for changes in specific factors. A community relatively heavily endowed with land will tend to have a comparative advantage in producing land—using food; equally, a community heavily endowed with capital will tend to have a comparative advantage in producing capital—inten— sive clothing. The pattern of world trade is closely linked to wide differences in re— source endowments. Trade encourages resources to move into sectors in which an economy enjoys a comparative advantage. Unlike the Ricardian model of Chapter 5, a country may nonetheless still support import—competing industries. The law of diminishing re~ turns helps to explain how a small amount of production may prove competitive, even though the community relies on imports to provide the bulk of its consump— tion of some items. All the essential features of the two—commodity model remain for economies char— acterized by a wide variety of productive activities, if in each industry use is made of some factor of production available in nationwide markets (e.g., labor), as well as other productive factors specifically tied to that industry. In particular, any change in relative prices of traded commodities or change in technology or discov— eries of new resources, is apt to have radical repercussions in various sectors of the economy. The Dutch disease describes how a favorable change in conditions affecting one tradeable sector can adversely affect other tradeable sectors by squeezing their profits (or returns to specific factors). For a small, open economy, cost increases may successfully be passed on to consumers in sectors protected from foreign competition by high costs of transport, even though such, relief is not available in traditional export— or import—competing sectors. l04 CHAPTER 6 TRADE AND LOCAL INCOME DISTRIBUTION: TI—IE SPECIFIC FACTORS MODEL Finally, note that all the changes discussed in this chapter, whether in com— modity prices, endowments, or technology, create losers as well as winners within countries. This is what is absent in Chapter 5, where the focus instead was on in— ter-country gains and losses. The specific—factors model yields many realistic re- sponses of internal income distribution to the forces Of globalization. As we shall see in the next chapter, a somewhat different scenario also suggests that distur— bances in international markets are capable of creating both winners and losers and an attendant disharmony in Opinions about trade policy. CHAPTER PROBLEMS mImmIIummmmmamwunmmmm/mmmmmmmmmmmmm/mm 1. SUGGESTIONS FOR FURTHER READING MIN/uIII/I’Mwanna:InMrMImuwanmmmmmmmwmmmwmmwwmmmmflmremnantmImu"WWIt!It/mWWWmnnlmmmwflmwmmmwmmmmwflwmmm mmmmwwwmummum The discussion of the Ricardian model in Chapter 5 introduced the concept of an input—output coefficient, a”. The reciprocal of this (1/aLF in the food sector, for ex— ample) referred tO the average product of labor. In a diagram that shows the mar— ginal product of labor, draw in a curve showing the average product of labor. How can land rents as well as total wages be shown in such a diagram? With reference to Figure 6.2 it was suggested that a 10 percent increase in the price of food would shift the VMPIfD curve upward by 10 percent, while a 10 percent in- crease in the supply Of land would (at constant food and Clothing prices) shift the VMPf curve rightward by 10 percent. Do these have equivalent effects on the wage rate? Which kind Of change would workers prefer? Which would capitalists prefer? Explain why Australian capitalists and landlords probably favor the same policy toward immigration. Given the traditional export position of Australian wool in world markets, how might owners Of sheep stations be expected to react to an in- crease in domestic prices of manufactures brought about by a tariff? Through what mechanism might land rents be disturbed? Contrast the effect on land rents of an increase in a nation’s supply of land coupled simultaneously with a reduction in its supply of capital if: a. The country cannot engage in world trade. b. The country does trade freely with a much larger world market. Answer the same two-part question if the nation’s supply of land remains constant while its supply of capital rises. Jones, Ronald W. “A Three—Factor Model in Theory, Trade, and History,” In J. Bhagwati, R. Jones, R. Mundell, and J. Vanek, eds., Trade, Balance of Payments and Growth (Amsterdam: North—Holland, 1971), Chapter 1 reprinted in R. W. Jones, International Trade: Essays in Theory (Amsterdam: North—Holland, 1979). APPENDIX l 05 Sets out the basic model and explores some applications to trade and economic theory. Mayer, Wolfgang. “Short—Run and Long—Run Equilibrium for a Small Open Economy,” journal of Political Economy, 82 (September/October 1974): 955-968. Interpretation of the specific—factors model as a short—run version of the Heckscher—Ohlin model in Chapter 7. WWW” mmrm THE TRANSFORMATION SCHEDULE These concepts now can be assembled in a diagram to describe an economy pos- sessing fixed overall amounts of three distinct productive factors: labor, land, and capital. Labor is used to produce both food and clothing; land is used only in food; and capital is specific to the clothing sector. These assumptions suffice to rule out the phenomenon associated with the Ricardian model, whereby an industry could expand by hiring more labor Withoutdriving up unit costs. Instead, production possibilities reflect increasing costs. Figure 6.A.| Production Possibilities with Diminishing Returns and Increasing Opportunity Costs The production possibilities curve in quadrant | is derived by picking a labor allocation along the full-employment line (quadrant ill) and displaying the outputs of food (quadrant II) and cloth- ing (quadrant IV) obtainable in quadrant l. Diminishing returns lead to increasing opportunity costs. Clothing l06 CHAPTER 6 TRADE AND LOCAL INCOME DISTRIBUTION: THE SPECIFIC FACTORS MODEL The bowed—out production possibilities curve is displayed in quadrant I of Figure 6.A.1, using the relationships drawn in quadrants II, III, and IV. Note espe- 1. Quadrant III shows a downward—sloping 45° line to illustrate the full employment of the economy’s total (fixed) labor resources, either to produce food (shown left- ward from the origin) or to produce clothing (measured downward from the origin). 2. The curves showing total labor productivity for the two industries (quadrants II and IV) illustrate diminishing returns to labor as more is applied to the fixed amount of the cooperating factor (land in the case of food and capital in the case of clothing). The production possibilities schedule in quadrant I reflects increasing opportu— nity costs. Endpoint D shows the maximum amount of food that could be pro- duced if all the economy’s labor force were employed in food. (OD also is shown by AC in quadrant II.) Similarly, endpoint F is the maximum clothing output, ob— tainable if labor force 0B is used to produce BE units of Clothing (quadrant IV). Any intermediate labor allocation, such as G in quadrant III, results in food output (H ] , quadrant II) and in clothing output (IK, quadrant IV) which is shown as point N on the transformation schedule (quadrant 1). Other points can be derived in sim— ilar fashion (e.g., labor allocation G’ yields output bundle N’——just complete the rectangle). Consider the movement from N to N’ that accompanies the labor re— - allocation from G to G’. As extra labor is poured into the clothing sector, dimin— ishing returns decrease labor’s productivity (in Clothing) at the margin. Meanwhile, the departure of labor from the food industry serves to raise the productivity Of the remaining food workers. On both counts, the relative cost of producing clothing rises (the transformation schedule becomes steeper). The transformation schedule bows out because labor is subject to diminishing returns in each sector, and the co— operating inputs (land for food, capital for clothing) are fixed in supply. ...
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CFJ6 - TRADE AND LOCAL INCOME DISTRIBUTION THE SPECIFIC...

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