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3 Gains and Losses from Trade in the Specific-Factors Model
Notes to Instructor
Chapter Summary
Chapter 3 develops a more robust model that includes all the factors of production. As in
the Ricardian model of Chapter 2, we ask the same questions: Does a country benefit
from trade and, if so, how are the gains shared among the factors of production? In the
Ricardian model that focused only on labor, we found that trade benefited not just world
production but also resulted in gains for all workers within open economies.
But, this chapter opened with a discussion of the Bolivian experience. The gains from
exporting natural gas clearly did not benefit the citizens of Bolivia. Many believed that
the gains had gone to the multinational oil corporations. This resulted in protests and a
continual succession of leaders over a short time span. It finally led to an eventual
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We will find that there are gains to be made in an open-trade economy, but these gains
may not be equally shared among all producers in the economy—owners of land, labor,
and capital.
This informs us of two things:
1. The relative price of manufacturing is equal to the opportunity cost of
In Autarky or a no-trade economy, equilibrium will occur where tangency occurs at the
consumer’s indifference curves on the PPF. This takes place at point A in Figure 3-3,
where the slope of the PPF is equal to the relative price of manufacturing (PM/PA ), which
is equal to the slope of the consumer’s indifference curve.
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The Foreign Country We will forgo a discussion on why the no-trade relative prices
differ across countries and just assume that the no-trade relative price of manufacturing at
∗/
∗). In other words, Home
Overall Gains from Trade In the absence of international trade, the economy produces
and consumes at the point on the PPF where the relative price of manufacturing is equal
This is an important inequality because it tells us that for Home to engage in export, it
must receive a relative price that is greater than PM/PA , and for Foreign to import, it must
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receive a price that is less than
∗/
∗.
This means that the relative price of Home’s manufactures will rise, while the relative
The world relative price (PM/PA )W is represented by the tangent line BC in Figure 3-3.
Suppose that the home country engages in trade that leads to an increase in the relative
price of the manufacturing good. The higher relative price of manufacturing, given by the
APPLICATION
How Large Are the Gains from Trade?
The United States experienced the reversal of gains from trade when the U.S. Congress
imposed an embargo on trade with Britain between December 1807 and March 1809. The
gains from trade for the United States would have been at least 5% of GDP without the
embargo. Put another way, the embargo cost the United States more than one third of the
value of exports.
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2 Earnings of Labor
We now address who gains from trade. If trade occurs, someone in the economy must be
better off. This does not imply that everyone is better off. Our goal now is to develop our
Determination of Wages Begin in a no-trade economy and consider wages in the two
sectors. We can put the marginal product of labor for agriculture and manufacturing on
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the same graph, as shown in Figure 3-4. The horizontal axis represents the total amount
of labor ̅, with the amount of labor used in manufacturing LM, measured from left (0M) to
Equilibrium Wage The equilibrium wage is given by the intersection of the marginal
product of labor in each sector multiplied by its respective price. With the equilibrium
Change in Relative Price of Manufactures We now know how the wage is determined
and equilibrium found in a no-trade economy. Let’s examine what happens when the
relative price of manufactures changes when the economy opens to trade. That is, what
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Trade Adjustment Assistance Programs: Financing the Adjustment Costs of Trade
We often talk about how an economy can benefit by engaging in international trade.
However, it is clear that not all sectors within the economy enjoy the overall gains from
H E A D L I N E S
Service Workers Are Now Eligible for Trade Adjustment Assistance
The TAA program, which was introduced by President John F. Kennedy in 1962, was
brought into the twenty-first century by the stimulus bill passed in 2009. But, to continue
3 Earnings of Capital and Land
In this section, we examine the effect of an increase in the relative price of manufactures
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on the rental of capital and land. In particular, which of the two specific factors gain
when the economy engages in international trade according to the specific-factors model?
Letting T represent the quantity of land in acres and K signify the number of physical
capital, we can use the preceding equations to show the rental on capital (earning per
capital), RK, and the rental on land (earning per acre), RT, by the following:
Alternatively, we could calculate the rentals by multiplying the marginal product of
the specific factor by its price:
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Similar to the formulation for wage, MPKM is the marginal product of capital in
manufacturing and MPTA is the marginal product of land in agriculture.
Change in the Real Rental on Capital To understand the effect of an increase in the
price of manufactures on the rental on capital, holding the agriculture price fixed, recall
that due to the change in the relative price of manufactures, the wage rises throughout the
economy. With the higher wage, labor shifts from agriculture into manufacturing, which
Change in the Real Rental on Land Contrary to the case for capital, however, the loss
of labor to manufacturing leads to a fall in the marginal product of agriculture. It follows
that the decline in MPTA means that the real rental on land in terms of food has fallen.
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Summary The general conclusion is given by the following: An increase in the relative
price of an industry’s output will increase the real rental earned by the factor specific to
that industry, but will decrease the real rental of factors specific to other industries.
Numerical Example Suppose the payments to labor and capital in manufacturing and
agriculture are given by the following:
Manufacturing: Sales revenue = PM · QM = $100
Note that 60% of sales revenue go to labor, while 40% go to capital.
Agriculture: Sales revenue = PA · QA = $100
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Assume in the agriculture sector that land and labor each earn 50% of the sales revenue.
We will maintain the preceding assumption that the increase in the relative price of
manufactures, PM/PA, occurs because of a rise in PM, holding PA constant. Suppose the
following price changes take place:
Change in the Rental on Capital Using the information given, we will determine the
impact of the increase in the price of manufactures on the rentals on capital and land.
We begin by rewriting the previous formula for the rental on capital in terms of
percentage change. Recall that the rental on capital is given as
