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Earnings of Labor
Earnings of
Capital and Land

• Opening a country to trade generates winners and


• Determining who gains and who loses answers

many questions about trade politics.

• Specific-Factors model helps explain who gains

and who loses.

• Short Run Specific-Factor model offers new

insights beyond the Ricardian model.
Specific-Factors Model
• How does trade affect the earnings of capital,
labor, and land?
• From the Ricardian model, free trade leads to:
 Rising relative prices in the export sector
 Falling relative prices in the import sector

• So what we really want to know is how changes in

relative prices affect the earnings of factors
Specific-Factors Model

• Why are we concerned with relative prices?

 The earnings of specific or fixed factors (such as
capital and land) go up or down the most with
changes in relative prices because they are “stuck” in
a sector and cannot be employed elsewhere.
 Mobile factors (such as labor) can offset losses from
changes in relative prices by seeking employment in
other sectors.
Specific-Factors Model

• Will continue to use two countries: Home and


• Home Country
 Manufacturing uses labor and capital.
 Agriculture uses labor and land.
 Diminishing returns to labor—decreasing MPLM and
MPLA (see Figure 3.2).
Specific-Factors Model

Diminishing Marginal Product of Labor

Figure 3.2
Specific-Factors Model

• Each country faces a standard Production

Possibilities Frontier.
 Concave to the origin because of diminishing returns to
labor in both industries.
 Suppose one unit of L moves from Agriculture to
Manufacturing: agricultural output falls by MPLA and
manufacturing output rises by MPLM.
 Thus, the slope of the PPF is the negative of the ratio of
the marginal products (see figure 3.3).
 The slope is the opportunity cost of producing one unit of
 If L continues to move to manufacturing, MPLA rises
and MPLM falls so the slope of the PPF gets steeper.
Specific-Factors Model
Production Possibilities Frontier

Figure 3.3
Specific-Factors Model

• Opportunity Cost and Prices

 As in the Ricardian model, the slope of the PPF equals
the opportunity cost or relative price of the good on the
horizontal axis: here it is manufacturing.
 Firms hire labor up to the point where the cost of one
more hour of labor (the wage) equals the value of one
more hour of labor in production.

Specific-Factors Model

• Opportunity Cost and Prices

 The value of the additional output can be measured by
multiplying the price of the good times the additional
output, or the MPL.

 This equality holds for both industries:

Specific-Factors Model
• Since we assume that
labor is mobile, the wages
in the two industries must
be equal. PM ⋅ MPLM = PA ⋅ PMLA
• Relative price of PM PMLA
manufacturing equals the =
opportunity cost of PA PMLM
manufacturing (slope of
Specific-Factors Model

• The no-trade position for Home is shown on the

next slide at point A

• In equilibrium
 PM/PA = −(slope of PPF) = −(slope of indifference curve)
 The indifference curve is tangent to PPF
Specific-Factors Model
Home Country without Trade
Output, QA

Slope = –(PM/PA)

Output, QM
Specific-Factors Model
• The Foreign Country
 Assume the no-trade price in the foreign country
(PM*/PA*) is higher than that in the Home Country

 For now we will ignore reasons for price differences.

 Home country has comparative advantage in
manufacturing (can produce at lower opportunity cost
than Foreign country).
Specific-Factors Model
• Overall Gains from Trade
 When trade opens the world price will end up between
the no-trade prices of the Home and Foreign countries.
 After trade
 Relative Home price of manufacturing will rise
 Relative Foreign price of manufacturing will fall
 Total gains from trade can be measured by the increased utility
of the higher indifference curve
Specific-Factors Model
Home Country with Trade

Output, QA
makesis opened
prices and
The gains from
consumers trade
faceinthe can be
Slope = –(PM/PA)W manufacturing
measured by the Home
rise in rise
as price,
seen fromthey
moveUto1 to U2.
a higher indifference
curve (U2)

A U2
Gains from trade
Slope = –(PM/PA)


Output, QM
Specific-Factors Model
• What has happened at Home?
 The relatively higher price in manufacturing attracts
more workers to that industry—production now at point
B (instead of A).
 Manufactured goods are exported and Agricultural
goods are imported.
 Consumption changes — moving individuals to a higher
indifference curve allowing them to now consume at C
(instead of A).
Specific-Factors Model

Old production = A
New production = B
Old consumption = A
New consumption = C
Specific-Factors Model

• Conclusions

 The good whose relative price increases becomes the

exported good.

 The good whose relative price decreases is the

imported good.

 A country can never be made worse off from trade.

Earnings of Labor
• Although a country as a whole is better off from trade, that
does not mean that every individual is better off.
• How are earnings of labor affected in importing and
exporting industries after trade?
• Determination of Wages
 We can show the amount of labor used in each industry on one

LM + LA = L
 Labor used in manufacturing is measured from the left axis.
 Labor used in agriculture is measured from the right axis.
 See Figure 3.5
Earnings of Labor

• Determination of Wages
 Firms hire up to the point where wages equal the value
of the marginal product.
 We can graph PM ∙ MPLM and PA ∙ MPLA in figure 3.5.

 Note that PA ∙ MPLA slopes upward because LA is

measured from the right.
 The equilibrium wage is at these curves’ intersection at
point A.
 As long as wages are equal in the two sectors, there is
no reason for labor to move between sectors.
Earnings of Labor
Allocation of Labor between
Manufacturing and Agriculture P
Labor Market
A*MPL A is drawn from
M*MPLM is drawn from
is where
two left
curves cross
Wage Wage
Value of
product of
Value of
PM ⋅MPLM marginal
product of

0M L → L ←L 0
    M                  A  A
Manufacturing Agriculture
Total labor
labor Figure 3.5
Earnings of Labor

• Change in Relative Price of Manufactures

 Assume the relative price of manufactures rises
(because of the foreign demand for them).
 We have already shown the shift from no-trade to trade
equilibrium on the PPF.
 Now we can look at the changes in the wage in each
industry and how these changes affect the real
earnings of labor.
 We will subsequently look at the real earnings of land
and capital owners.
Earnings of Labor
• Effect of Wage
 A rise in relative price of manufacturing can be caused by an
increase in PM or a decrease in PA.

 Effect on real wage is the same.

 Assume PM rises
 PM*MPLM curve shifts up by Δ PM ∙ MPLM
 New equilibrium at higher wage
 LM has increased and LA has decreased
 Figure 3.6
Earnings of Labor

Figure 3.6 Increase in the Price of The vertical distance

PM*MPLM shifts up creating
Manufactured Goods between the old and new
a new equilibrium.
curves is greater than the
increase in wages.
Wage Vertical Wage
= ∆PM ⋅(MPLM)




0M L → L L′ ←L 0
    M                  A  A
Earnings of Labor

• Effect on Real Wages

 Do higher wages translate into higher real wages?
Depends on changes in prices.

 We assumed PA did not change so W/PA has increased

—workers can buy more food.

 We assume that PM increased, as did W; what is the

net effect on W/PM?
Earnings of Labor

• Effect on Real Wages

 We showed in figure 3.6 that
 If we divide both sides by W we get:

< =
 ΔW/W is the percentage change in wages
Earnings of Labor

• Effects on Real Wages

 ΔPM/PM is the percentage change in the price of
manufactured goods.

 Since ΔW/W is a smaller increase, the amount of

manufactured goods that can be purchased with the
money wage has fallen.

 The real wage in terms of manufactured goods has

Earnings of Labor
• Overall Impact on Labor
 Is labor better off or worse off after the price increase?
 A person who spends more of his or her income on agricultural
goods is better off.
 But a person who spends more of his or her income on
manufactured goods is worse off.
 In the specific-factors model, the overall effect on the well-being of
workers is thus ambiguous.

• Although ambiguous, this conclusion is important.

 The result is different than what was found in the Ricardian
model, where labor unambiguously earned a higher real wage.
 This warns us that one cannot make unqualified statements
about the effects of trade on workers.
• The effect of trade on real wages can be complex.
Earnings of Labor
• Unemployment in Specific Factors Model
 Total labor is always LM + LA so no unemployment.
 Why do we ignore unemployment?
 Unemployment is usually considered a macro phenomenon
affected by business cycles.
 Many people laid off due to trade often find new jobs within a
reasonable amount of time, often with higher wages.

 Even if we were to consider the spells of unemployment

due to trade, we see that workers can find new jobs
typically in the expanding exporting industry.
 Even after we take into account that workers eventually
find new jobs, we still cannot conclude whether trade is
necessarily good or bad for workers
Manufacturing and Services in the US

• Manufacturing Services in the U.S.: Employment
and Wages Across Sectors.
• Figure 3.7 shows employment in U.S.
manufacturing industry over time.
• Figure 3.8 shows real wages earned by
production workers in manufacturing, all private
services, and in information services.
Manufacturing and Services in the US

Manufacturing and Services in the US

Manufacturing and Services in the US

• Conclusions
1. Wages differ across different sectors in the economy,
so the assumption that wages are the same in both
industries is a simplification.
2. Many workers that are displaced every year for various
reasons must find jobs elsewhere.
 Some are laid off because of import competition, but
there are many other reasons
3. The majority of workers find new jobs within 2–3 years,
but not necessarily at the same wage
4. Real wages for all production workers fell in most
years between 1972–95, but have since risen.
Manufacturing and Services in the US

Job Losses in Manufacturing and Service Industries, 2003–2005

Source: U.S. Bureau of Labor Statistics, http://www.bls.gov/news.release/disp.nr0.htm

Earnings of Capital and Land
• Although there are “overall” gains from trade for
the country, we have found that labor, the mobile
factor, does not necessarily gain
• What about the earnings of the other factors of
production, capital and land, which cannot switch
between industries?
• Determining the Payment to Capital and Land
 Capital and Land earn what is left over from sales
revenue after labor is paid.
 Total revenue is price times the quantity sold, and
payments to labor are wages times quantity hired.
Earnings of Capital and Land
• Determining the Payment to Capital and Land
 Payments to capital = PM∙QM – W∙LM
 Payments to labor = PA∙QA – W∙LA
 Taking the payments one step further will be useful.
 Quantity of land used in agriculture is T acres.
 Quantity of capital used in manufacturing is K.

 We can now determine the earnings of capital, RK, and

land, RT
Payments to capital PM QM − WLM
RK = =
Payments to land PAQA − WLA
RT = =
Earnings of Capital and Land
• Determining the Payment to Capital and Land
 RK and RT are the rental rates on capital and land respectively,
which reflect what these factors earn during a given period
when used in these industries.
 Also, the amount the factors could earn if rented to someone
else over the same time.
 We can also use another method to calculate the rental on
capital and land.
 We can consider the value of the additional output we get from
hiring those factors.

Earnings of Capital and Land
• Change in the Real Rental on Capital
 Assume PM increases as before, PA constant.
 We saw before that wages rise and labor shifts from
agriculture to manufacturing.
 As more labor is used in manufacturing, the marginal product of
capital will rise.
 As more labor leaves agriculture, the marginal product of land
will fall.

 General Conclusion:
An increase in the quantity of labor used in an industry
will raise the marginal product of the factor specific to
that industry, and a decrease in labor will lower the
marginal product of the specific factor.
Earnings of Capital and Land

• We can get more from this conclusion:

 Remember MPKM = RK/PM
 PM is rising and we know MPKM is rising.
 RK must be increasing by more than PM is increasing, in
percentage terms.
 Also remember RK/PA is amount of food that can be
purchased by capital owners.
 RK increased, PA fixed, so RK/PA increases.
 Real rental on capital is the amount of food that can be
Earnings of Capital and Land

• Change in the Real Rental on Capital

 Since capital owners can afford more of both goods,
they are better off when PM rises.

 This is unlike the case of labor, which could buy more

of one good but less of the other.

 The owners of capital are clearly better off under trade

than in the no-trade case.
Earnings of Capital and Land

• Change in the Real Rental on Land

 Labor leaves agriculture, causing MPKA to fall.
 Since MPKA = RT/PA, RT/PA must fall, meaning RT itself
must fall (since PA remains constant).
 This means the real rental on land in terms of food has
decreased—landowners cannot buy as much food.
 And PM has increased, so landowners cannot buy as
much of the manufactured good either.
 Landowners are clearly worse off with trade than in the
no-trade case.
Earnings of Capital and Land
• Summary
 Real earnings of capital owners and landowners move
in opposite directions.
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.
 This means that, generally, specific factors in export
industries gain, and specific factors in importing
industries lose.
Numerical Example
• Manufacturing:
 Sales Revenue = PMQM = $100
 Payments to Labor = WLM = $60
 Payments of Capital = RKK = $40

• Agriculture
 Sales Revenue = PAQA = $100
 Payments to Labor = QLA = $50
 Payments to Land = RTT = $50

• Assume PM increases by 10% and PA remains unchanged.

Percentage change in labor is 5%
 ΔPM/PM = 10%
 ΔPA/PA = 0%
 ΔW/W = 5%
 Remember the percent change in wages will be between the
percent change in the two industry price changes.
Numerical Example

• Change in the Rental on Capital

Payments to Capital PM QM −WLM
RK = =
∆RK =
Rewriting using percentage changes gives :
∆RK ( ∆PM PM ) PM QM − ( ∆W W ) WLM
Numerical Example
• Change in the Rental on Capital
 ΔRK/R = (10%*100-5%*60)/40 = 17.5%

 The percentage increase in rental on capital is greater

than percentage increase in the relative price of
manufacturing, 10%
 This holds no matter what, given that the percentage
increase in the wage is less than the percentage
increase in the price of the manufactured good.
Numerical Example

• Change in Rental on Land

 Using the same analysis, we can look at how rental
rates are affected by an increase in PM

0(QA ) − ∆WLA
∆RT =
 We know that wages are increasing which means the
rental on land is falling. We can calculate how much.
Numerical Example
• Change in Rental on Land
• Land rent falls by same percentage as
wage increases.
 This occurs because we assumed labor and
land received the same share of sales revenue

∆RT ∆W  WLA 
=−  
RT W  RT T 
∆RT  50 
= −5%  = −5%
RT  50 
Earnings of Capital and Land

• General Equation for the Change in Factor Prices

 All changes in factor and industry prices are related.
 Assume PM increases and PA does not change, then:

∆RT ∆W ∆PM ∆RK

<0< < <
Earnings of Capital and Land

• General Equation for the Change in Factor Prices

 The opposite is true if PM falls.
 Wages fall by less than percent change in the
manufactured good, rental on capital falls by more
than the manufacturing price, and rental on land rises.
 What happens if PA increases?

RK W PA RT

0  
What It All Means

• The earnings of specific factors change the most

from relative price changes due to international
• This is because these factors (land and capital)
cannot move between industries.
• The earnings changes are in opposite directions
and so the interests of T and K are opposed to
each other.
• Changes in wages paid to labor are less extreme.