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Chapter Four
Trade, Distribution, and
Welfare
Copyright © 2003 South-Western/Thomson Learning
Chapter Four Outline
1. Introduction
2. Partial and General Equilibrium
Analysis
3. Stolper-Samuelson Theorem
4. Factor Price Equalization Theorem
5. Specific Factors Model
6. Trade and Welfare: Gainers, Losers,
and Compensation
2
Introduction
• Time to examine some of the major
contributions international trade theory has
made to general-equilibrium analysis.
– We will look at the primary reason for the
controversy between policies of free trade and
policies of protectionism.
3
Partial and General Equilibrium Analysis
• General-equilibrium analysis
– Interrelationships among various markets in the
economy.
• Extreme example would be a model of a world economy
that includes every good, every input, and every country
and in which everything depended on everything else.
• Partial-equilibrium analysis
– Focuses on events in one or two markets and
assumes others remain unaffected.
• Simple example: analysis of effect of a Florida freeze on
prices of orange juice.
4
Effect of Output Prices on Factor Prices
• Stolper-Samuelson Theorem
– Link between changes in output prices and
changes in factor prices.
– Most general form: an increase in the relative
price of a good increases the real return to the
factor used intensively in that good’s production
and decreases the real return to the other factor.
• Factor prices change proportionally more than output
prices (magnification effect).
See Figure 4.1
5
Figure 4.1: How Does Trade Affect the Demand
for Inputs in a Labor-Abundant Country?
rA
wA
LA
KA
rA0
wA2
DAL1
DAL2
rA2
wA0
A
K2
D
DAK1
A
L0
D
0
LA
(a) Labor Market
L
0
KA
DAK0
K
(b) Capital Market
6
Effect of Output Prices on Factor Prices
• In Figure 4.1, as production of the laborintensive good increases, opening trade
generates a net increase in demand for labor.
– Net effect on demand for capital is negative,
because production of the capital-intensive good
falls.
– With fixed factor endowments, the reward paid to
the abundant factor rises and that paid to the
scarce factor falls.
• The wage-rental ratio under restricted trade exceeds the
ratio under autarky.
7
Effect of Output Prices on Factor Prices
• When assumptions of Heckscher-Ohlin model
are added, the Stolper-Samuelson theorem
means that opening trade raises the real
reward to the abundant factor and lowers the
real reward to the scarce factor.
– Trade boosts production of the good of
comparative advantage, increasing that good’s
opportunity cost and relative price.
• See Table 4.1 for trade’s effects on production, output
prices, and factor prices.
8
How Do Factor Prices Vary Across
Countries?
• The Factor Price Equalization Theorem
– According to Stolper-Samuelson theorem, moving
from autarky to unrestricted trade raises the real
reward of the abundant factor.
• Similarly, such a move lowers the real reward of the
scarce factor.
• Same adjustment takes place in the second country, but
with the roles of the two factors reversed.
– Trade raises the real reward of a factor in a country
where that factor is abundant and lowers its price in
the country where it is scarce.
9
How Do Factor Prices Vary Across
Countries?
– Thus, even when factors are immobile between the
two countries, unrestricted trade in goods tends to
equalize the price of each factor across countries.
• With free trade in goods and no international factor
mobility, wA = wB and rA = rB.
– This is idea behind Factor Price Equalization
Theorem.
• Table 4.2 (page 111) summarizes the theorem’s
implications, assuming country A is labor-abundant and
good X is labor intensive.
10
How Do Factor Prices Vary Across
Countries?
• Figure 4.2 illustrates how a firm’s costminimizing production techniques change.
– To increase production of the labor-intensive good
(X), firms in both industries must increase their
capital-labor ratios.
• The rise in wage-rental ratio from (w/r)0 to (w/r)1 brings
about this adjustment.
– Firms choose to use less labor and more capital as
labor becomes more expensive relative to capital.
See Figure 4.2
11
Figure 4.2: Changes in Factor Cause Firms to
Change Their Capital-Labor Ratios
KX
KY
Slope = – (w/ r)1
Slope = – (w/ r) 1
(K/L) Y1
(K/L) X1
Slope = – (w/ r) 0
Slope = – (w/ r)0
(K/L) Y0
(K/L) X0
Y
X
LX
0
(a) X Industry
LY
0
(b) Y Industry
12
How Do Factor Prices Vary Across
Countries?
• The factor price changes predicted by the
factor price equalization theorem provide the
firm an incentive to undertake the necessary
changes in production techniques.
– Profit-maximizing firms will choose to use more of
the scarce factor as it becomes relatively cheaper
and less of the abundant factor as it becomes
relatively more expensive.
• This “economizing” on use of the abundant factor
allows the country to specialize in producing the
comparative advantage good.
13
An Alternate View of Factor Price
Equalization
• Trade in outputs serves as a “substitute” for
trade in factors of production.
– For example, when a labor-abundant country
exports a unit of a labor-intensive good, it
indirectly exports labor to a labor-scarce country.
• Unrestricted trade in either output or input markets can
serve as a substitute for trade in the other markets.
14
Why Don’t We Observe Factor Price
Equalization?
• Full factor price equalization is never
observed.
– In Figure 4.3, it is shown that wages, before
corrections for differences in labor productivity,
differ widely across countries (by a factor of 20).
• Reason #1: Uneven ownership of human and nonhuman
capital yields inequality of wealth.
• Reason #2: Not all countries use identical technology in
production…some are more advanced than others.
– Causes factor productivity to vary across countries.
See
Figure 4.3
15
Figure 4.3: Hourly Compensation for Manufacturing
Production Workers, 1999 (U.S.=100)
16
Why Don’t We Observe Factor Price
Equalization?
• Figure 4.4 shows that relative factor price
differences across countries match relative
productivity differences.
– Countries with high (low) labor productivity
relative to that of the U.S. have high (low) wages
relative to the U.S.
– Countries with high (low) capital productivity
relative to the U.S. have high (low) rental rates.
See
Figure
4.4
17
Figure 4.4a: Factor Prices Reflect
Productivity
Wage/U.S. Wage
1.2
(a) Labor Productivity and Wages
Canada
1.0
US
Switzerland
Austria
New Zealand Netherlands
Italy Denmark
UK Belgium
W. Germany
Japan
Sweden
Norway
Israel
France
Ireland Spain
Finland
0.8
0.6
0.4
Greece
Singapore
Portugal Colombia
Panama Hong Kong
Indonesia Yugoslavia
Thailand
Pakistan, Sri Lanka
Bangladesh
0.2
0
0
0.2
0.4
0.6
0.8
1
1.2
Labor Productivity/U.S. Labor Productivity
18
Figure 4.4b: Factor Prices Reflects
Productivity
Rental Rate/U.S. Rental Rate
(b) Capital Productivity and Rents
1.8
Sweden
1.6
1.4
Norway
Hong Kong
1.2
Switz.
Austria NZ
Singapore Greece
Ireland
Italy Spain
Yugoslavia Trinidad
Israel
Portugal
Panama
Thailand
Pakistan
Colombia
1.0
0.8
0.6
Canada
U.S.
Bangladesh
Belgium, Finland, Germany
Uruguay
Indonesia
0.4
0.2
0
Japan
UK
Netherlands
Denmark
Sri Lanka
0
0.2
0.4
0.6
0.8
1
1.2
Capital Productivity/U.S. Capital Productivity
19
Why Don’t We Observe Factor Price
Equalization?
• Complete output price equalization may not
occur due to transportation costs, barriers to
trade, and existence of goods that are rarely
traded.
– The factor price equalization theorem suggests an
important policy alternative:
• Allow free trade in outputs, specialize in labor-intensive
production, and export labor indirectly in the form of
labor-intensive goods.
– Countries such as Ireland, the Philippines, India,
Jamaica, and Singapore have begun using new
technologies to do just that.
20
What if Factors Are Immobile in the
Short-Run?
• Previous assumptions were that factors are
completely mobile among industries within a
country and completely immobile among
countries.
– In the short-term, mobility of factors may
be imperfect.
• Short-run effects of opening trade may differ from longrun effects captured by Stolper-Samuelson and factor
price equalization theorems.
21
Reasons for Short-Run Factor Immobility
• Physical capital: machines and factories
– Most equipment is specialized…it is suited only for
the specific purpose for which it was designed.
– As physical capital wear out from use and age, firms
set aside funds (depreciation allowances) to replace
the equipment.
• Funds can be used to buy a different type of capital.
• Labor capital – same arguments apply.
– As older workers retire and new ones enter the labor
force, the skill distribution slowly changes in favor of
growing industries and away from shrinking ones.
22
Effects of Short-Run Factor Immobility
• Figure 4.5 illustrates that an increase in the
price of shoes raises the wage rate in both the
shoe and the computer industries, but by less
than the rise in the price of shoes.
– The return to capital specific to the shoe industry
rises more than proportionally with the price of
shoes, and the return to capital specific to the
computer industry falls.
See Figure 4.5
23
Figure 4.5a: Effect on Factor Markets of an
Increase in an Output Price with a Specific
Factor
ws
wc
ws1
ws2
wc2
ws0
wc0
VMPLs1
VMPLs0
VMPLc0
0s
L0
LA
L2
0c
(a) Labor
24
Figure 4.5b: Effect on Factor Markets of an
Increase in an Output Price with a Specific
Factor
rs
rs2
SKA
rs1
VMPSK
2
VMPSK
1
rs0
VMPSK
0
0
SK
(b) Shoe Capital
25
Figure 4.5c: Effect on Factor Markets of an
Increase in an Output Price with a Specific
Factor
CKA
rc
rc0
rc1
VMPCK
0
VMPCK
1
0
CK
(c) Computer Capital
26
Effect of a Rise in Shoe Prices on Factor
Prices when Capital is Immobile
• Wage rates rise in both industries, but by less
than the price of shoes.
– Effect on workers’ purchasing power depends on
shares of shoes and computers in workers’
consumption.
• The return to shoe capital rises more than the price of
shoes, so owners of shoe capital enjoy an increase in
buying power regardless of their pattern of
consumption.
• Return to computer capital falls, so those owners suffer
a loss of purchasing power regardless of their pattern of
consumption.
27
Trade with an Industry-Specific Factor
• Continue with a case in which labor is highly
mobile among industries, but capital is immobile in
the short-run.
– Country has a comparative disadvantage in laborintensive shoe production and comparative advantage
in capital-intensive computer production – it opens
trade with another country.
• Shoe production falls and computer production rises.
• If both labor and capital were mobile between two industries,
newly employed workers from shoe industry would flow into
computer industry, and computer industry would buy unused
capital from shoe industry.
28
Trade with an Industry-Specific Factor
• In our example, in the short-run, capital
employed in the computer industry and
workers who buy more shoes than computers
gain from the opening of trade.
– And, capital employed in shoe industry and
workers who buy more computers than shoes lose.
– In the long-run, owners of capital, the factor used
intensively in computer production, gain from the
opening of trade.
• And, workers, the factor used intensively in shoe
production, lose.
29
Trade with an Industry-Specific Factor
• The existence of factors specific to single
industries creates a short-run rigidity, or
limitation on the economy’s ability to
reallocate production among industries
quickly and at a low cost.
– The more industry-specific the factors of
production, the more costly will be any adjustment
to relative price changes in terms of temporary
unemployment or underutilization of capital.
30
Trade and Welfare: Gainers, Losers, and
Compensation
• Opening trade increases the total quantity of
goods available and makes it possible for
everyone to gain.
– In order for everyone to gain, a portion of the
gains enjoyed by some would have to be used to
compensate others for their losses.
• If this were done, society as a whole would be made
better off by trade.
– In general, however, no automatic mechanism to
make this compensatory redistribution exists.
31
Potential versus Actual Utility
• Figure 4.6 shows that trade allows production
of larger quantities of goods, making a higher
indifference curve attainable (potentially to
make every individual better off – if, for
example, the additional goods were distributed
among all individuals).
See
Figure 4.6
32
Figure 4.6: Trade Increases Potential
Welfare
Y
2
Y2
Y1
1
U2
U1
0
X1
X2
X
33
Comparing Utility: The Pareto Criterion
• If, as shown in Fig. 4.6, after moving from
point 1 to point 2, the additional goods were
distributed such that every person ended up
with more of such a good
– Then you could say that this move increased actual
welfare or utility according the the Pareto
Criterion.
• States that any change that makes at least one person
better off without making any individual worse off
increases welfare.
34
Comparing Utility: The Compensation
Criterion
• Opening trade harms some groups.
– How can gainers from a policy gain enough to
allow them to compensate the losers for their losses
and still enjoy a net gain?
• Opening international trade satisfies this Compensation
Criterion for welfare improvement.
– Because the world economy produces more goods
with trade, gainers can, in principle, compensate
losers and still be better off.
• Such compensation, though possible, rarely occurs.
35
Trade Adjustment Assistance
• International trade is dynamic – industries are
always making adjustments in order to
maintain competitive advantages.
– These adjustments cause certain losses.
• Temporary unemployment
• Relocation
• Retraining
– U.S. government administers the Trade
Adjustment Assistance (TAA) program.
• Provides variable compensation for workers displaced
for trade-related reasons…see Table 4.5.
36
Notes on Case Two: Trade and Wages II: The
United States
• Figure 4.7 illustrates that from the mid-1970s
until the present, wages of high-income
workers have risen relative to those of lowincome workers.
– Trend stems mainly from changes in technology
rather than from international trade.
• Increased importance of knowledge-intensive skills has
increased demand for workers who possess those skills.
See Figure 4.7
37
Figure 4.7: Indexed Weekly Wages of White
Males, 1940–1990, (1940 = 100)
250
90th percentile a
200
150
10th percentile a
100
1940
1950
1960
1970
1980
“a” refers to percentiles of the wage distribution, where workers in the 99th percentile have the
highest earnings.
1990
38
Summary
• General equilibrium analysis incorporates the
interrelationships among various markets in
the world economy.
– In Figure 4.8, the Heckscher-Ohlin, StolperSamuelson, and factor price equalization theorems
link markets in countries that allow trade in goods.
See
Figure 4.8
39
Figure 4.8: General-Equilibrium Linkages in Our
Basic Trade Model
Gains from Trade
Terms of Trade
tt
(P X/P Y)
Productive Specialization
Comparative Advantage
Output Prices
A
(P X/P Y)
Output Prices
B
(P X/P Y)
Heckscher-Ohlin
Theorem
StolperSamuelson
Theorem
Incomes
Factor Prices
A
(w/r)
StolperSamuelson
Theorem
Factor-Price
Equalization Theorem
Factor Prices
B
(w/r)
Incomes
Demand for
Outputs
Demand for
Factors
Supply of
Factors
Supply of
Factors
Demand for
Factors
Demand for
Outputs
Tastes
A
U (X,Y)
Technology
aLX, a KX, a LY, a KY
Endowment
A
A
L ,K
Endowment
B
B
L ,K
Technology
b LX, b KX, b LY, b KY
Tastes
B
U (X,Y)
40
Key Terms in Chapter 4
• General-equilibrium analysis
• Partial-equilibrium analysis
• Magnification effect
• Stolper-Samuelson theorem
• Factor price equalization theorem
• Depreciation allowance
• Pareto criterion
41
Key Terms in Chapter 4
• Compensation criterion
• Trade Adjustment Assistance (TAA)
42