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Globalization, Growth, and Trade Lectures 13-14: Specific Factors Model (SFM) 0 Overview - Today Motivation: Bringing ‘structure’ of economy into trade discussion, a quick look at global export shares and comparative advantage Overview of the Specific Factors Model (SFM) Analytical pieces of the SFM Production function Production possibility frontier Production function and implied factor returns 4 quadrant model (labor, 2 production functions, possibility frontier) Trade, production and factor payments in the SFM Analysis: winners and losers from global market shocks 1 Regional export shares by sector 2 Primary product export shares Latin Am: 50% avg., but 85% for Andean countries 60% of Mercosur inc. Bolivia and Chile; Over 65%: Argentina, Belize, Bolivia, Chile, Colombia, Nicaragua, Panama, Paraguay, Peru, Uruguay, Venezuela Under 40% - Costa Rica and Mexico Comparative advantage of most of LA is clear S.S. Africa: most countries are mainly primary exporters 4 countries with <70% (Togo, Senegal, South Africa, Mauritius) 6 with 70-80% share (Guinea, Kenya, Madagascar, Niger, Zambia, Zimbabwe) The other 25 have > 80% primary export share 3 Comparative Advantage Comparisons If export shares => comp advantage, then most of L Am & Africa have comparative advantage in primary products. What implications might this have for development? Why does it matter to poverty? Recall that Yh = wLh + rKh: how would expanding primary products shape household incomes? What does your answer depend on? Why might you be concerned about the poverty implications of comparative advantage in primary products versus manufacturing? We can get more on this once we dig further into our next trade model 4 Political economy implications HO-SS predicts aggregate gains from trade, but also losses for some groups --> Functional (self-interest) basis for some positions on trade: Owners of abundant factors in favor Owners of scarce factors opposed Examples? 5 Overview of Specific Factors Model (SFM) 2 good model (like H-O) But capital (or natural resource) is specific to sectors (cannot be moved to other sector) Does this make sense? Can a coffee farm become a clothing factory in short term? In long term? In SFM, only labor is mobile between sectors Use SFM to study how changes in trade patterns, FDI, and technology affect economic structure and incomes when factor-specificity limits adjustment Helps us to see winners and losers from trade in a slightly different way. Production function – 1 sector Factors of production Production function Diminishing returns VMP and factor payments 7 Production Function Rice (tons) ƒx(L, K) 28 27 25 20 0 10 20 30 40 Labor days • Constant returns to scale in (L,K), so dim. returns to L when quantity of K is fixed 8 Production Function (more K -> more rice) ƒx(L, K+) Rice (tons) ƒx(L, K) 28 27 25 20 0 10 20 30 40 Labor days • Constant returns to scale in (L,K), so dim. returns to L when quantity of K is fixed (irrigated paddy) 9 Calculating Factor Returns X slope = w/px X = (w/px)Lx + πx ƒx(K,L) X0 Revenue = costs πx X*px = w*Lx + rx*Kx or: X = (w/px)Lx + πx where: πx = (rx/px)*Kx 0 Lx 0 Lx • Assume: wage = value of labor’s marginal product • Return on labor (= wage) = slope of tangent to function • Return on stock of sector-specific capital is height 0πx = (rx/px)Kx 10 (Derivation of factor returns) Total revenue of the firm: pxX = wL + rxKx By assumption, the value of output is fully divided between workers and capital owners Dividing both sides by px: X = (w/px)L + (r/px)Kx = (w/px)L + πx Note: w/px is known as the product wage in sector X Distribution between L and K: X – (w/px)L = πx Higher wage (steeper slope on w/px) implies lower profit share. Flatter slope implies higher profit share 11 The specific factors model Assume 2 goods, X and M Each sector uses specific capital, Kx, Km --> prod’n fns yj = ƒj(L, Kj), j = X, M Labor is ‘mobile’ (can be reallocated) between X and M production Total labor force is fixed and fully employed: L = Lx + Lm In equilibrium, same wage offered in both sectors For given Kx and Km, when labor is fully employed, can only increase output (create jobs) in one industry by reducing output (destroying jobs) in the other 12 General Equilibrium – Supply Side Production function M M Prod’n Poss. Frontier, Maps total production possible given PFs and labor ƒm(Lm,Km) L 0 50 X Production function x ƒx(Lx,Kx) Labor constraint 45o 50 L 13 Autarky (no trade) M • uA MA •L 0 m L pA •XA X Lx • LA 45o L 14 From Autarky to Trade p* > pA • M uT • MA uA pA • MT p* •L • m L 0 •XA • XT MT < M A LMT < LMA … uT = uA LT = LA X Lx • LA • LT L 15 Trade, income, distribution in SFM Integration with world economy raises aggregate real income & cons. welfare Structure of production and labor allocation change in predictable ways What happens to returns to specific factors? (hint: Stolper-Samuelson - see notes from Week 1) What happens to the real wage? 16 Aggregate Income M uT uA pA pT 0 L YA YT X LA Compare old and new incomes at constant prices! LT 45o L 17 (Aggregate income change) YT = aggregate income from production of the combination (XT, MT) valued at world prices pT, measured in terms of good X (the value of X that could be bought with that much income) Compare: YA = aggregate income from production of the combination (XA, MA), valued at world prices pT, measured in terms of good X YT > YA says the economy is better off in aggregate 18 Changes in factor payments (w/pM)T slope = M pA MA (w/pM)A T M L LA LT 0 XA TX pT X 45o L 19 (Changes in factor payments) Moving from autarky to trade raises X output and employment, lowers M output and employment Demand for KX rises; πXT > πXA Demand for KM falls; πMT > πMA Demand for L in M falls; with KM fixed , law of diminishing returns says that productivity of remaining workers rises, so (w/pM)A < (w/pM)T Demand for L in X rises; with KX fixed, (w/pX)A > (w/pX)T Are workers better off or worse off? 20 Comparative Advantage in Agriculture Capitalists (Km) Landowners (Kx) Workers (L) Effect of rise in px on nominal inc. Effect of rise in px on real inc. (a) When consume mostly X (b) When consume mostly M 21 Comparative Advantage in Agriculture Capitalists (Km) Landowners (Kx) Workers (L) lose gain gain (a) When consume mostly X lose gain lose? (b) When consume mostly M lose gain gain? Effect of rise in px on nominal inc. Effect of rise in px on real inc. 22 Comparative Advantage in Manufacturing Capitalists (Kx) Landowners (Km) Workers (L) Effect of rise in px on nom. income Effect of rise in px on real inc. (a) When consume mostly X (b) When consume mostly M 23 Comparative Advantage in Manufacturing Capitalists (Kx) Landowners (Km) Workers (L) gain lose gain (a) When consume mostly X gain lose lose? (b) When consume mostly M gain lose gain? Effect of rise in px on nom. income Effect of rise in px on real inc. 24 Distributional & poverty effects Real specific factor returns follow own prices: for a rise in px/pm, πx will rise, πm will fall Real wage change is indeterminate: Wage rises rel. to pm, but falls rel. to px H’hold welfare: aggregate has risen, but Gains for owners of capital in X Losses for owners of capital in M Workers’ welfare change is ambiguous 25 Discussion If we have data on asset ownership & cons. patterns, can compute changes in Rh and poverty for groups Poverty effects depend on distribution of assets as well as on changes in payments such as wages and rents Notice that we have assumed labor is mobile between sectors. Realistic? What if it is not? SFM vs H-O: which is more realistic? When? What about more complex models, for example with some endogenous product prices (nontradables?) See next class… 26