Specific Factors and Income

Distribution
Day 4
This lecture is covered from KOM (Chapter 4)
Specific Factor Model
• This model is developed by Paul Samuelson and Ronald Jones.
• Like Ricardian model, the primary model is also based on two goods.
• There is only one factor of production in the Ricardian model.
• How does the PPF look like for a Ricardian model and why?
• In a Specific Factor Model, one factor is specific to all goods, while
other factors are specific.
Assumptions
• Two goods: cloth and food.
• Three factors of production: Capital 𝐾 , labor 𝐿 , and land 𝑇 .
• Labor is the mobile factor which can be used in all sectors.
• Capital is exclusively used for the cloth production while land is
exclusive to the food sector.
• Cloth production function: 𝑄! = 𝑄! (𝐾, 𝐿! )
• Food production function: 𝑄" = 𝑄! (𝑇, 𝐿" )
• Labor supply is fixed at 𝐿 and 𝐿 = 𝐿! + 𝐿"
Production Possibilioties
• How the economy’s mix of output changes as the labor shifts from
one sector to another?
• Illustrate the relationship between 𝑄! and 𝐿! .
• For a given supply of capital 𝐾, ↑ 𝐿! ⇒↑ 𝑄! .
• What is the name of the slope of the 𝑄! function?
• Marginal product of labor: additional output produced by adding one
more person-hour.
• For a given supply of capital 𝐾, what should be the relationship
between 𝐿! and 𝑀𝑃𝐿! ? Why?
• 𝑀𝑃𝐿! gets flatter with a rise in 𝐿! .
Production Possibilioties
• Ricardian PPF: It shows what the economy can produce.
• Specific Factor Model PPF: how much of a good can be produced for a
given amount of another good and vice-versa.
• Four quadrant diagram for PPF:
• Bottom-right and top-left: PPF of the two goods.
• Downward movement along vertical axis: ↑ 𝐿! ⇒↑ 𝑄!
• Leftward movement along horizontal axis: : ↑ 𝐿" ⇒↑ 𝑄"
• Bottom-left: allocation of labor.
• 𝐿! and 𝐿" are inversely related as 𝐿 is fixed.
• This one-to-one relationship is shown by a 45-degree line.
• The top-right corner illustrates the PPF.
Production Possibilioties
• The PPF looks like a curve. What does it reflect? Why is it different
than the Ricardian PPF?
• The curvature stems from the diminishing returns to labor in each sector. The
Ricardian PPF is a straight line due to the constant opportunity cost.
• Suppose one person-hour is shifted from food to cloth.
• Rise in cloth by 𝑀𝑃𝐿! units (to increase cloth by 1 unit, we have to raise labor
"
input by #$% (unit labor requirement?)
!
• Food production will fall by 𝑀𝑃𝐿& .
#$%"
• To increase cloth by 1 unit, the economy has to sacrifice #$% units of food.
!
Production Possibilioties
• What is the slope of PPF?
• What is the opportunity cost of cloth in terms of food?
• ↑ 𝐿! ⇒↓ 𝑀𝑃𝐿! and ↓ 𝐿" ⇒↑ 𝑀𝑃𝐿" : How does the slope of PPF look
like? Steeper or flatter? Why?
• As more labors are shifted from food to cloth, each additional unit of labor
becomes less valuable in cloth sector and more valuable in food sector.
Price, Wage and Labor Allocation
• Demand for labor in each sector depends on the price of output and wage
rate.
• Wage rate depends on the combined demand for labors of all sectors.
• A firm will demand labor upto the point where the value produced by an
additional person-hour equals the cost of employing that hour.
𝑃! ∗ 𝑀𝑃𝐿! = 𝑤
• As ↑ 𝐿! ⇒↓ 𝑀𝑃𝐿! , for a given 𝑃! , 𝑃! ∗ 𝑀𝑃𝐿! will go down.
• Downward sloping labor demand curve (↑ 𝑊 ⇒↓ 𝐿! ).
• Similarly, 𝑃" ∗ 𝑀𝑃𝐿" = 𝑤.
• Why is the wage rate same for all sectors?
• How do we get the optimal allocation of labor across the sectors?
QUIZ!!!
• What should be relationship between relative price and opportunity
cost?
Price, Wage and Labor Allocation
• Recap from the last lecture:
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.
• What happens to the allocation of labor and the distribution of
income when the prices of food and cloth changes?
Two types of changes:
ü An equal proportional change in both
ü A change in only one price
EqualProportional Change in Price
• % Δ𝑃! = % Δ𝑃" (How will it change the relative price?)
• There will be rise in wage and % Δ𝑤 = % Δ𝑃! = % Δ𝑃" .
• No change in the real wage.
• No change in labor distribution.
• No change in the real income of capital owners and land owners.
• No change in the relative quantity.
Change in Relative Prices
• Let % Δ𝑃! > % Δ𝑃" . For simplicity, assume that % Δ𝑃" = 0 .
• Definitely, there will be a rise in wage, but how much? Is it % Δ𝑤 =
% Δ𝑃! ? Why or why not?
• There will be redistrinbution of labor from one sector to another (i.e.,
↑ 𝐿! and ↓ 𝐿" .
• ↑ 𝐿! =↑ 𝑄! and ↓ 𝐿" =↓ 𝑄" .
• Can you whow the whole thing in a PPF combining the new relative
price?
• Can we illustrate a positive relationship between relative price and
relative quantity (i.e., relative supply curve)?
Relative Prices and Distribution of Income
• So far we have seen
1. The determination of production possibilities given an economy’s resources and
technology.
2. The determination of resource allocation, production and relative prices in a
market economy.
• Still the story is not considering the existence of international trade.
• What is the effect of changes in relative prices on the distribution of
income?
üThe factor specific to the sector whose relative price increases is definitely better off.
üThe factor specific to the sector whose relative price decreases is definitely worse
off.
üThe change in welfare for the mobile factor is ambiguous.
International Trade in the Specific Factor
Model
• Trade will take place when a country faces a world relative price that
differs from the relative price that would prevail in the absence of
trade.
• After the integration, the world relative supply curve will be different
than the pre-trade relative supply curve.
• An economy exports the good whose relative price has increased and
imports the good whose relative price has decreased.
Income Distribution and Gains from Trade
• Ttrade benefits the factor specific to the export sector of each
country but hurts the factor specific to the import competing sectors,
with ambiguous effects on the mobile factor.
• Could those who gain from the trade compensate those who lose and
still be better of themselves? If so, then trade is a potentially a source
of gain to everyone.
• Trade will expand the range of choice, and everyone may end up with
a higher consumption of all goods.
• The reality is different!
International Labor Mobility
• Labor moves from low-wage country to high-wage country.
• Convergence of real wage rates.