Pretty Easy: Specific Factors Model (4quadrant, Labour Diagram, Autarky To Trade)

Question 1

People oppose trade because it affects distribution of income within a country

Why? (2)

Answer 1

Resources cannot move immediately/costlessly
(Reason for not full specialisation! (Why under free trade price ratio is not tangent to PPF - factors cannot adjust)

Industries differ in factors of production they demand (require SPECIFIC FACTORS!)

Question 2

So role of specific factors model

Answer 2

Allows trade to affect income distribution

Question 3

2 goods X & Y
Labour used for both goods
X uses specific capital K
Y uses specific capital T

Production functions for X and Y
B) total labour endowment

Answer 3

X =X(Lx,K)
Y =Y(Ly,T)

B) total labour endowment
LX + LY = L

Question 4

Labour is used for both goods.

What happens when labour shifts from one sector to the other e.g from Y to X

B) how is this diagrammed

Answer 4

When labour moves from Y to X, production Y falls while output of X rises at a slowing rate.

B)
Y axis - good X X axis - LX
upward sloping concave (to show it slows down as Lx increases)

Question 5

Four quadrant diagram

Answer 5

Y axis top - Output of Y
Y axis bottom - Lx
X axis right - Output of X
X axis left - Ly

Top-left quadrant is production function for Y
Bottom-right is production function for X
Top right is PPF (simple one)
Bottom left is full-employment locus (Lx+Ly=Lbar) (linear)

Draw the dotted line to see the simultaneous relationships between the quadrants

Question 6

Why is PPF (top right quadrant) curved?

B) how do we express opportunity cost of producing 1 more X

Answer 6

Since opportunity costs increase as you produce more of a good.

B) MPLy/MPLx units of Y

Question 7

So back to our example of moving labour from Y to X.
What happens to opportunity cost of producing X?

Answer 7

It means we produce less Y and more X as explained. And so MPLy increases, and MPLx falls

Using the expression for opportunity cost on previous FC, opportunity cost increases!

Question 8

What is firm decision within specific factors model

Answer 8

Maximise profits - demand labour up to where value produced of an additional hour = MC of employing for that hour.

MPLx * Px = VMPLx (=w)
MPLy * Py = VMPLy (=w)

(same as HO model where VMP = price x MP)

Question 9

What if we increase the amount of the specific (fixed) factor? (specific=fixed factor as RMB labour is mobile hence wages are equal in sectors)

E.g an increase in Kbar

Effect on diagram

Answer 9

More capital to work with now, so MPL increases.
Shift upwards in demand for labour for good X (Lx)

(More capital to work with, higher K/L ratio i.e higher MPL for given labour)

Question 10

Equilibrium allocation of labour diagram (both Lx and Ly) pg 10

Answer 10

2 demand curves (MPLx and MPLy) intersect gives wage (since equal) , and allocation of labour between the 2 sectors X and Y

(Tip: starts off with normal labour market diagram for X)

Question 11

What would autarky general equilibrium equation be

b) and the diagram pg11

Answer 11

Recall PPF slope (opportunity cost) MPLy/MPLx

MPLy/MPLx = Px/Py
(PPF slope = Price ratio)

B) easy
PPF sloped just like in the four quadrant diagram. Then add the price slope Px/Py tangential

Question 12

Effect of equi-proportional price change e.g 10% rise in price of both X and Y

B) diagram

Answer 12

Increase in demand for labour for both since price rises.

Leads to a 10% rise in wages, so real incomes remain
No change in labour allocation or output

B) simple shift upwards in demand for both

Question 13

So when would price changes actually change the allocation of labour and distribution of income?

Answer 13

If RELATIVE prices change.

(Since if prices increase for both proportionally then relative prices remain constant i.e EQUI-PROPORTIONAL)

Question 14

Now see effect of a rise in price of just good X

Answer 14

Relative price of X is more, only labour demand for X increases, MPLx shifts upwards.

Labour allocation has changed: produces more X

Wages: rise but less than the price rise in X!

Question 15

So who benefits and loses from this increase in Px?
(Discuss wage earner in general, then owners of specific factors)

Answer 15

Ambiguous effect on wage - gain IN TERMS OF Y! (since price of Y constant, but wage has risen)
And they lose in terms of X (wage has risen but less than Px) so thus benefit and loss!)

Owners of capital K (specific factor for good X) gain, since demand for labour for X increases. (and Px has risen more than their wage costs! E.g 10% increase in Px means wage increases but not as much!)

Owners of capital T (specific factor for good Y) lose, since labour moves to X but pay new higher wage

Question 16

General results for the relationship between returns to factors and prices, for a rise in Px is…

Answer 16

r^x > P^x > w^ > P^y > r^y

Real return to the specific factor (K) used for the good with the price rise (Px) increases

Real return to the specific factor (T) used for the good that remained the same price (P^y) decreases.

W is ambigiuous (since gain in terms of Y, since wage rises but Py constant, and lose in terms of X, Px rises more than wage)

Question 17

Effect of change in a SPECIFIC factor on production e.g an increased endowment of T (specific capital used for good Y)

(Capitalised since we will see the effect of mobile factor (labour) is different)

Answer 17

More specific factors for Y, so more workers within industry Y have more capital to work with, so labour productivity in Y increases, thus nominal incomes rise and output rises in Y

Output falls in the other sector

Question 18

Effect on returns on
A) mobile factor
B) both specific factors

Answer 18

Mobile factor (labour) - Increased real returns (since wages have risen, prices haven’t changed)

Specific factor: decreased real returns to both

EXPLANATION: dont need to RMB why for T, T increases and labour in sector Y increases (T/L , both T and L increase but workers get less productive as cannot offer them all the same wage, so T/L is higher, meaning MPT becomes less productive and rT falls)

Question 19

That was a change in SPECIFIC factor. Now consider MOBILE.

Effect of increased endowment of L (the mobile factor)

How to draw on diagram

Answer 19

Increases output of both sectors (will initially work in the sector with the higher wages, however they equalise hence why increases output for both)

B) extend horizontally, and shift right in curve in Ly to Ly*

Question 20

Effect of increased L on returns

A) mobile factor
B) both specific factors

Answer 20

Mobile factor: decreased real returns (higher supply of labour so wages fall)

Specific factors: Increases real returns (since more labour per the capital MPK and MPT rise so rK and rT)

Question 21

Now add trade to the model

Assume country A has more of specific factor K

What does country A produce, and the effect on price?

B) diagram

Answer 21

Country A produces relatively more of good X
Thus relative price of good X is lower in country A

B)
Shift upwards in demand for labour for X. (Lx)
Since need more Lx in country A than Lx in country B. Thus wages in A are higher

Question 22

In the specific factors model what will counties export

Answer 22

Specialise and export the good they have a comparative advantage and abundance in

Question 23

Without trade (autarky) what must happen to an economy’s output

Answer 23

Output must equal its consumption

Trade allows this to not be true

Question 24

Trade in SF model

Diagram

Answer 24

Yes, as economy consumes more, so on average better-off.

Eval:
Not every individual will be better off due to redistribution effects

B) FREE TRADE PRODUCTION IS TANGENT TO CIC2 BUT NOT TANGENT TO PPF, because producers have specialised but not fully!

Question 25

Why have producers not specialised fully (i.e why is free trade price ratio not PPF not tangent to PPF)

B) Gains from trade in the SF model?

Answer 25

As in short run equilibrium - recall assumption that resources cannot move immediately or costlessly. Factors have not had time to adjust.

Yes, as economy consumes more, so on average better-off.

Eval:
Not every individual will be better off due to redistribution effects (as mentioned wage is ambiguous, and effect on owners of specific factors)

Question 26

If exam question is outline model

Answer 26

Assumptions
Implications under
A) autarky
B) free trade
C) gains from trade & sources of gains from trade e.g sources of gains could be from exchange, specialisation, or consumers being able to consume a variety
Finally outline Criticisms

E.g HO has 2 FOP so concave PPF i.e DMR