Chapter 3

Specific Factors and Income Distribution

Prepared by Iordanis Petsas

To Accompany
International Economics: Theory and Policy,
Policy Sixth Edition
by Paul R. Krugman and Maurice Obstfeld

Chapter Organization
Introduction
The Specific Factors Model
International Trade in the Specific Factors Model
Income Distribution and the Gains from Trade
The Political Economy of Trade: A Preliminary View
Summary
Appendix: Further Details on Specific Factors

Introduction
Trade has substantial effects on the income

distribution within each trading nation.

There are two main reasons why international trade
has strong effects on the distribution of income:

Resources cannot move immediately or costlessly

from one industry to another.
Industries differ in the factors of production they
demand.

The specific factors model allows trade to affect

income distribution.

The Specific Factors Model

Assumptions of the Model
Assume that we are dealing with one economy that can produce

two goods, manufactures and food.

There are three factors of production; labor (L), capital (K) and
land (T for terrain).
Manufactures are produced using capital and labor (but not
land).
Food is produced using land and labor (but not capital).
Labor is therefore a mobile factor that can be used in either
sector.
Land and capital are both specific factors that can be used
only in the production of one good.

Perfect Competition prevails in all markets.

The Specific Factors Model

How much of each good does the economy produce?
The economys output of manufactures depends on how
much capital and labor are used in that sector.

This relationship is summarized by a production function.

The production function for good X gives the maximum
quantities of good X that a firm can produce with various
amounts of factor inputs.
For instance, the production function for manufactures
(food) tells us the quantity of manufactures (food) that can
be produced given any input of labor and capital (land).

The Specific Factors Model

The production function for manufactures is given by
QM = QM (K, LM)

(3-1)

where:
QM is the economys output of manufactures
K is the economys capital stock
LM is the labor force employed in manufactures

The production function for food is given by

QF = QF (T, LF)
where:
QF is the economys output of food
T is the economys supply of land
LF is the labor force employed in food

(3-2)

The Specific Factors Model

The full employment of labor condition requires that
the economy-wide supply of labor must equal the labor
employed in food plus the labor employed in
manufactures:
LM + LF = L

(3-3)

We can use these equations and derive the production

possibilities frontier of the economy.

The Specific Factors Model

Production Possibilities
To analyze the economys production possibilities, we
need only to ask how the economys mix of output
changes as labor is shifted from one sector to the other.

Figure 3-1 illustrates the production function for

manufactures.

The Specific Factors Model

Figure 3-1: The Production Function for Manufactures
Output, QM
QM = QM (K, LM)

Labor input, LM

The Specific Factors Model

The shape of the production function reflects the law of
diminishing marginal returns.
Adding one worker to the production process (without
increasing the amount of capital) means that each worker
has less capital to work with.
Therefore, each additional unit of labor will add less to the
production of output than the last.

Figure 3-2 shows the marginal product of labor, which

is the increase in output that corresponds to an extra unit
of labor.

The Specific Factors Model

Figure 3-2: The Marginal Product of Labor
Marginal product
of labor, MPLM

MPLM
Labor input, LM

The Specific Factors Model

Figure 3-3: The Production Possibility Frontier in the Specific Factors Model
Output of food,
QF (increasing )

Production function
for food
QF =QF(K, LF)

Q2F

1'

Economys production
possibility frontier (PP)
2'
3'

Labor input in
food, LF
(increasing )

Q2M

L2F
L2M

1
2

Economys allocation
of labor (AA)

AA

Labor input
in manufactures,
LM (increasing )

PP

Output of
manufactures, QM
(increasing )
Production function
for manufactures

QM =QM(K, LM)

The Specific Factors Model

Prices, Wages, and Labor Allocation
How much labor will be employed in each sector?
To answer the above question we need to look at supply
and demand in the labor market.

Demand for labor:

In each sector, profit-maximizing employers will
demand labor up to the point where the value produced
by an additional person-hour equals the cost of
employing that hour.

The Specific Factors Model

The demand curve for labor in the manufacturing
sector can be written:
MPLM x PM = w

(3-4)

The wage equals the value of the marginal product of

labor in manufacturing.

The demand curve for labor in the food sector can be

written:
MPLF x PF = w
The wage rate equals the value of the marginal
product of labor in food.

(3-5)

The Specific Factors Model

The wage rate must be the same in both sectors,
because of the assumption that labor is freely
mobile between sectors.

The wage rate is determined by the requirement

that total labor demand equal total labor supply:
LM + LF = L

(3-6)

The Specific Factors Model

Figure 3-4: The Allocation of Labor
Wage rate, W

Wage rate, W

PF X MPLF
(Demand curve
for labor in food)

W1
PM X MPLM
(Demand curve for labor in
manufacturing)
Labor used in
manufactures, LM
L1M

Labor used
in food, LF
L1F
Total labor supply, L

The Specific Factors Model

At the production point the production possibility
frontier must be tangent to a line whose slope is
minus the price of manufactures divided by that of
food.

Relationship between relative prices and output:

-MPLF/MPLM = -PM/PF

(3-7)

The Specific Factors Model

Figure 3-5: Production in the Specific Factors Model
Output of food, QF

Slope = -(PM /PF)1

Q1F

PP
Q1M

Output of manufactures, QM

The Specific Factors Model

What happens to the allocation of labor and the
distribution of income when the prices of food and
manufactures change?

Two cases:
An equal proportional change in prices
A change in relative prices

The Specific Factors Model

Figure 3-6: An Equal Proportional Increase in the Prices of Manufactures and Food
PM X MPLM
2

Wage rate, W
PM X MPLM

PF 2 X MPLF
Wage rate, W

W2

PM
increases
10%

PF increases
10%

PF 1 X MPLF

10%
wage
increase

W1

Labor used in
manufactures, LM

Labor used
in food, LF

The Specific Factors Model

When both prices change in the same proportion, no
real changes occur.
The wage rate (w) rises in the same proportion as the
prices, so real wages (i.e. the ratios of the wage rate to
the prices of goods) are unaffected.
The real incomes of capital owners and landowners also
remain the same.

The Specific Factors Model

When only PM rises, labor shifts from the food sector
to the manufacturing sector and the output of
manufactures rises while that of food falls.

The wage rate (w) does not rise as much as PM since

manufacturing employment increases and thus the
marginal product of labor in that sector falls.

The Specific Factors Model

Figure 3-7: A Rise in the Price of Manufactures
Wage rate, W

7%
upward
shift in
labor
demand

Wage
W2
rate
rises by W 1
less than
7%

PF X MPLF
1

Wage rate, W

2
1

PM 2 X MPLM
PM 1 X MPLM

Labor used in
manufactures, LM

Amount of labor
shifted from food
to manufactures

Labor used
in food, LF

The Specific Factors Model

Figure 3-8: The Response of Output to a Change in the
Relative Price of Manufactures

Output of food, QF

Slope = - (PM /PF)1

Q1F

Q2F

2
Slope = - (PM /PF) 2
PP

Q1M

Q2M

Output of
manufactures, QM

The Specific Factors Model

Figure 3-9: Determination of Relative Prices
Relative price
of manufactures, PM /PF

(PM /PF )1

RS

RD

(QM /QF )1

Relative quantity
of manufactures, QM/QF

The Specific Factors Model

Relative Prices and the Distribution of Income
Suppose that PM increases by 10%. Then, we would
expect the wage to rise by less than 10%, say by 5%.

What is the economic effect of this price increase on

the incomes of the following three groups?
Workers
Owners of capital
Owners of land

The Specific Factors Model

Workers:
We cannot say whether workers are better or worse off;
this depends on the relative importance of manufactures
and food in workers consumption.

Owners of capital:
They are definitely better off.

Landowners:
They are definitely worse off.

International Trade
in the Specific Factors Model
Assumptions of the model
Assume that both countries (Japan and America) have
the same relative demand curve.
Therefore, the only source of international trade is the
differences in relative supply. The relative supply might
differ because the countries could differ in:
Technology
Factors of production (capital, land, labor)

International Trade
in the Specific Factors Model
Resources and Relative Supply
What are the effects of an increase in the supply of
capital stock on the outputs of manufactures and food?
A country with a lot of capital and not much land will
tend to produce a high ratio of manufactures to food at
any given prices.

International Trade
in the Specific Factors Model
Figure 3-10: Changing the Capital Stock
Wage rate, W

Increase
in capital
stock, K

PF 1 X MPLF

Wage rate, W

2
W

W1

PM X MPLM2
PM X MPLM1

Labor used in
manufactures, LM

Amount of labor
shifted from food to
manufactures

Labor used
in food, LF

International Trade
in the Specific Factors Model
An increase in the supply of capital would shift the
relative supply curve to the right.

An increase in the supply of land would shift the

relative supply curve to the left.

What about the effect of an increase in the labor force?

The effect on relative output is ambiguous, although
both outputs increase.

International Trade
in the Specific Factors Model
Trade and Relative Prices
Suppose that Japan has more capital per worker than
America, while America has more land per worker
than Japan.

As a result, the pretrade relative price of manufactures

in Japan is lower than the pretrade relative price in
America.

International trade leads to a convergence of relative

prices.

International Trade
in the Specific Factors Model
Figure 3-11: Trade and Relative Prices
Relative price of
manufactures, PM /PF

RSA
RSWORLD

(PM /PF )A

RSJ

(PM /PF )W
(PM /PF )J
RDWORLD
Relative quantity of
manufactures, QM/QF

International Trade
in the Specific Factors Model
The Pattern of Trade
In a country that cannot trade, the output of a good
must equal its consumption.

International trade makes it possible for the mix of

manufactures and food consumed to differ from the
mix produced.

A country cannot spend more than it earns.

International Trade
in the Specific Factors Model
Figure 3-12: The Budget Constraint for a Trading Economy
Consumption of food, DF
Output of food, QF
Budget constraint
(slope = -PM/PF)

Q1F

Production possibility curve

Q1M

Consumption of manufactures, DM
Output of manufactures, QM

International Trade
in the Specific Factors Model
Figure 3-13: Trading Equilibrium
Quantity of
food

Quantity of
food

Japanese budget constraint

American budget constraint

Americas QA
F
food
A
exports D F

Japans DJ
F
food
imports QJF

DJM QJM Quantity of

manufactures

Japans
manufactures
exports

Q A M DA M
Americas
manufactures
imports

Quantity of
manufactures

Income Distribution and

the Gains from Trade
To assess the effects of trade on particular groups, the
key point is that international trade shifts the relative
price of manufactures and food.

Trade benefits the factor that is specific to the export

sector of each country, but hurts the factor that is
specific to the import-competing sectors.

Trade has ambiguous effects on mobile factors.

Income Distribution and

the Gains from Trade
Could those who gain from trade compensate those
who lose, and still be better off themselves?

If so, then trade is potentially a source of gain to

everyone.

The fundamental reason why trade potentially

benefits a country is that it expands the economys

choices.

This expansion of choice means that it is always

possible to redistribute income in such a way that

everyone gains from trade.

Income Distribution and

the Gains from Trade
Figure 3-14: Trade Expands the Economys Consumption Possibilities
Consumption of food, DF
Output of food, QF

1
F

Budget constraint
(slope = - PM/PF)
PP

Q1M

Consumption of manufactures, DM
Output of manufactures, QM

The Political Economy of Trade:

A Preliminary View
Trade often produces losers as well as winners.
Optimal Trade Policy
The government must somehow weigh one persons gain
against another persons loss.

Some groups need special treatment because they are already

relatively poor (e.g., shoe and garment workers in the United
States).
Most economists remain strongly in favor of more or less free
trade.

Any realistic understanding of how trade policy is

determined must look at the actual motivations of policy.

The Political Economy of Trade:

A Preliminary View
Income Distribution and Trade Politics
Those who gain from trade are a much less
concentrated, informed, and organized group than
those who lose.
Example: Consumers and producers in the U.S. sugar
industry

Summary
International trade often has strong effects on the
distribution of income within countries, so that it
often produces losers as well as winners.

Income distribution effects arise for two reasons:

Factors of production cannot move instantaneously
and costlessly from one industry to another.
Changes in an economys output mix have differential
effects on the demand for different factors of
production.

Summary
A useful model of income distribution effects of
international trade is the specific-factors model.

In this model, differences in resources can cause

countries to have different relative supply curves, and

thus cause international trade.
In the specific factors model, factors specific to export
sectors in each country gain from trade, while factors
specific to import-competing sectors lose.
Mobile factors that can work in either sector may
either gain or lose.

Summary
Trade nonetheless produces overall gains in the sense
that those who gain could in principle compensate
those who lose while still remaining better off than
before.

Appendix:
Further Details on Specific Factors
Figure 3A-1: Showing that Output Is Equal to the Area Under the
Marginal Product Curve
Marginal Product of
Labor, MPLM

MPLM
dLM

Labor input, LM

Appendix:
Further Details on Specific Factors
Figure 3A-2: The Distribution of Income Within
the Manufacturing Sector
Marginal Product of
Labor, MPLM

Income of
capitalists

w/PM
Wages

MPLM
Labor input, LM

Appendix:
Further Details on Specific Factors
Figure 3A-3: A Rise in PM Benefits the Owners of Capital
Marginal Product of
Labor, MPLM

Increase in
capitalists income
(w/PM)1
(w/PM)2
MPLM
Labor input, LM

Appendix:
Further Details on Specific Factors
Figure 3A-4: A Rise in PM Hurts Landowners
Marginal Product of
Labor, MPLF

Decline in landowners
income
(w/PF)2
(w/PF)1
MPLF
Labor input, LF