CHAPTER 3

SPECIFIC FACTORS AND INCOME DISTRIBUTION

Chapter Organization

The Specific Factors Model

Assumptions of the Model
Box: What is a Specific Factor?
Production Possibilities
Prices, Wages, and Labor Allocation
Relative Prices and the Distribution of Income
International Trade in the Specific Factors Model
Resources and Relative Supply
Trade and Relative Prices
The Pattern of Trade
Income Distribution and the Gains From Trade
The Political Economy of Trade: A Preliminary View
Optimal Trade Policy
Box: Specific Factors and the Beginnings of Trade Theory
Income Distribution and Trade Politics
Summary
Appendix: Further Details on Specific Factors
Marginal and Total Product
Relative Prices and the Distribution of Income

CHAPTER OVERVIEW

The analysis presented in the previous chapter, demonstrating unambiguous gains from trade,
may leave students wondering why free trade is such a politically charged issue and why
protectionism is so heatedly discussed in the press. The reason for this is that the debates
concerning free trade focus on its distributional rather than its efficiency effects. A formal
examination of these effects requires a model which has factors of production linked to
producing certain goods. Two models of this nature are presented in this chapter.

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The first model includes factors of production which are inexorably tied to producing one
and only one good. The particular example presented in the text involves winemakers and
cheesemakers. The immobility of labor prevents equalization of wages. The production
possibility frontier of this economy is a rectangle and the relative supply curve is a vertical
line. An equilibrium relative price can be determined when the relative demand curve is
specified.

Consider the effect of introducing another country which can produce the same bundle of
goods. The second economy shares the same production technology, but has different
relative amounts of each type of labor. Trade between these two economies benefits each in
the aggregate since the possible consumption set of each country expands. However,
distributional issues arise when trade is permitted since workers in particular sectors may not
gain from trade. There will be no gain for the labor in each economy which was relatively
scarce prior to trade as compared to after trade. The type of labor relatively abundant in a
country will gain from trade. The source of this effect is the movement in relative prices
which favors the good which was relatively abundant in each country before trade. The
general outcome is that trade benefits workers in the export sector of each country and hurts
workers in the import-competing sector.

Next, a more general model is presented to investigate the distributional effects of trade.
This specific factors model allows an examination of the distributional effects of trade on
factors inexorably tied to the production of a specific good as well as on a factor that can be
used to produce either good. The three factors in this model include two specific factors,
land and capital, as well as one inter-sectorally mobile factor, labor. The fixed amount of
each specific factor results in diminishing returns to labor. The mobility of labor ensures an
equal wage in the production of either good, and perfect competition ensures that the wage
equals the value marginal product of labor in the production of each good.

A graphical analysis demonstrates the distribution of labor between sectors as well as the
return to labor. International trade alters the relative prices of goods and thus the amount of
labor used in each sector, the real wage to labor and the returns to capital and land. The
results of this model are similar to that of the immobile factors model in that owners of
factors specific to export sectors in from trade while owners of factors specific to import
sectors lose from trade. This model also shows that trade has an ambiguous effect on mobile
factors. To reinforce the importance of these concepts, the instructor may present data on

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who lobbies for protection and in which industries. Newspapers and magazines are often
useful and timely sources of relevant information.

The models presented in this chapter provide a framework for a preliminary discussion of the
political economy of trade. The general support for free trade among economists despite its
income distributional effects is justified. One reason for this support is that the benefits of
free trade are widely dispersed while its costs are concentrated. Economists may better serve
the country as advocates for the general welfare since there is no shortage of advocates for
particular groups injured by trade. The issue of the political economy of trade reappears
throughout the book. An appendix provides further details on the specific factors model.

ANSWERS TO TEXTBOOK PROBLEMS

1. Texas and Louisiana are states with large oil-producing sectors. The real wage of oil-
producing factors of production in terms of other goods falls when the price of oil falls
relative to the price of other goods. This was the source of economic decline in these
states in 1986.

2. To analyze the economy's production possibility frontier, consider how the output mix
changes as labor is shifted between the two sectors.
a. The production functions for goods 1 and 2 are standard plots with quantities on the
vertical axis, labor on the horizontal axis, and Q 1= Q1(K1,L1) with slope equal to the
MPL1, and on another graph, Q2= Q2(K2,L2) with slope equal to the MPL2.

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 Figure 3-1

b. To graph the production possibilities frontier, combine the production function

diagrams with the economy's allocation of labor in a four quadrant diagram. The
economy's PPF is in the upper right hand corner, as is illustrated in the four quadrant
diagram above. The PPF is curved due to declining marginal product of labor in each
good.

3. a. To solve this problem, one can graph the demand curve for labor in sector 1,
represented by (w=MPL1=demand for L1) and the demand curve for labor in sector 2,
represented by (w=MPL2=demand for L2) . Since the total supply of labor is given by
the horizontal axis, the labor allocation between the sectors is approximately L 1=27
and L2=73. The wage rate is approximately $0.98.

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 Figure 3-2

b. Use the same type of graph as in problem 2b to show that sectoral output is Q 1=44 and
Q2=90. (This involves combining the production function diagrams with the
economy's allocation of labor in a four quadrant diagram. The economy's PPF is in the
upper right hand corner, as illustrated in the text.)
c. Use a graph of labor demands, as in part a, to show that the intersection of the demand
curves for labor occurs at a wage rate approximately equal to $0.74. The relative
decline in the price of good 2 caused labor to be reallocated: labor is drawn out of
production of good 2 and enters production of good 1 (L 1=62, L2=38). This also leads
to an output adjustment, whereby production of good 2 falls to 68 units and
production of good 1 rises to 76 units.
d. With the relative price change from p2/p1=2 to p2/p1=1, the price of good 2 has fallen
by 50 percent, while the price of good 1 has stayed the same. Wages have fallen, but
by less than the fall in p2 (wages fell approximately 25 percent). Thus, the real wage
relative to p2 actually rises while to real wage relative to p1 falls. Hence, to determine
the welfare consequences for workers, information is needed about their consumption
shares of good 1 and good 2.

4. The box diagram presented below is a useful tool for showing the effects of increasing
the supply of the mobile factor of production, labor.
a. For an economy producing two goods, X and Y, with labor demands reflected by their
marginal revenue product curves, there is an initial wage of w 1 and an initial labor

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 allocation of Lx=OxA and Ly=OyA. When the supply of labor increases, the right
boundary of this diagram is pushed out to Oy'. The demand for labor in sector Y is
pulled rightward with the boundary. The new intersection of the labor demand curves
shows that labor expands in both sectors, and therefore output of both X and Y also
expand. The relative expansion of output is ambiguous. Wages paid to workers fall.

Figure 3-3

b. From the shape of the MPL curves, it is clear that labor will continue to exhibit
diminishing returns. Using a four quadrant diagram, you can demonstrate that the new
production possibility frontier is more concave and steeper (flatter) at the ends. Using
the numerical example, L1 increases to 90 from 62 and L2 increases to 50 from 38.
Wages decline from $0.74 to $0.60. This new allocation of labor yields a new output
mix of approximately Q1=85 and Q2=77.

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FURTHER READING

Avinash Dixit and Victor Norman. Theory of International Trade. Cambridge: Cambridge
University Press, 1980.

Michael Mussa. "Tariffs and the Distribution of Income: The Importance of Factor
Specificity Substitutability and Intensity in the Short and Long Run." Journal of Political
Economy 82 (1974) pp.1191-1204.

J. Peter Neary. "Short-Run Capital Specificity and the Pure Theory of International Trade."
Economic Journal 88 (1978) pp.488-510.

Mancur Olson. The Logic of Collective Action. Cambridge: Harvard University Press, 1965.

David Ricardo. The Principles of Political Economy and Taxation. Homewood Illinois:
Irwin, 1963.

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