International Trade

HW #2 Answers – Specific Factors Model

Problem 1

Because the United States is an oil-importing country, a sharp decrease in the price of oil would improve the United States' terms of trade and most Americans would perceive the price decrease as good for the US economy. But states that produce oil would experience an economic decline. Why?

ANSWER: Suppose that two goods are produced – oil and food. Oil is produced with Capital and Labor, while food is produced with Land and Labor. Suppose further that $p_{o i l}$ falls while $p_{f o o d}$ remains unchanged.

Using "^" to denote a percentage change:

\hat{p_{o i l}} < 0

\hat{p_{f o o d}} = 0

In such a case, the percentage decrease in the return to the factor specific to oil production (i.e. the return on Capital) will be greater than the percentage decrease in the price of oil:

\hat{r_{K}} < \hat{p_{o i l}} < \hat{w} < \hat{p_{f o o d}} < \hat{r_{T}}

Notice that the real return on Land as measured in terms of oil and as measured in terms of food will rise:

\hat{r_{T}} > \hat{p_{o i l}} \Rightarrow \frac{r_{T}}{p_{o i l}} ↑

\hat{r_{T}} > \hat{p_{f o o d}} \Rightarrow \frac{r_{T}}{p_{f o o d}} ↑

The real wage measured in terms of oil will rise, while the real wage measured in terms of food will fall:

\hat{w} > \hat{p_{o i l}} \Rightarrow \frac{w}{p_{o i l}} ↑

\hat{w} < \hat{p_{f o o d}} \Rightarrow \frac{w}{p_{f o o d}} ↓

And the real return on Capital as measured in terms of oil and as measured in terms of food will fall:

\hat{r_{K}} < \hat{p_{o i l}} \Rightarrow \frac{r_{K}}{p_{o i l}} ↓

\hat{r_{K}} < \hat{p_{f o o d}} \Rightarrow \frac{r_{K}}{p_{f o o d}} ↓

So most Americans would perceive the price decrease as good for them. Owners of land would experience an unambigous increase in their purchasing power. Workers would see their wages rise relative to the price of oil, but fall relative to the price of food. But states that produce oil (owners of capital) would experience decrease in their purchasing power.

Problem 2

The Specific Factors model explains how international trade can affect the distribution of income within a country. Why do economists object to using protectionist trade policy to mitigate or reverse those distributional effects? What alternative proposals would economists suggest to mitigate the distributional effects of trade?

ANSWER: Economists object to using protectionist policies to mitigate the distributional effects on the relative incomes of different factors of production because the gains to society exceed the losses faced by specific groups.

If policymakers wanted to mitigate or reverse those effects, economists would recommend taxing the groups that gain from trade and transferring the revenue to the groups that lose from trade.

Problem 3

Why might groups of people who lose from international trade be more informed, cohesive and motivated than groups who gain from trade? Discuss.

ANSWER: Groups that who lose from international trade are more informed, cohesive and motivated because they have more to lose from an expansion of trade than others have to gain.

For example, suppose that the Total Cost of a trade barrier (in terms of higher prices) is $10,000 and the Total Benefit is $5000. Suppose further that the cost of the trade barrier is spread over 1000 people, but the benefit is concentrated among 50 people. In such a case, the cost is spread such that each member of society would pay $10 (on average), but the benefit is concentrated among 50 people who gain $100 (on average).

Consequently, those who lose from trade are more motivated to advocate trade barriers – hiring lobbyists, running TV commercials, etc.

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