Factor-proportions theory. Countries have different endowments of factors of production some are capital-abundant (high K/L) some are labor-abundant (low K/L) Different industries have different requirements for K and L some are capital-intensive some are labor-intensive.
The labor surplus is (theoretically) cured by a fall in wages, which motivates reduced labor market participation.
The capital shortage is cured by a rise in rents, which motivates more saving and investment.
Bottom line: opening of trade has reduced the income of the scarce factor of production (labor) while increasing the income of the abundant factor of production (capital)
The rise in rents and fall in wages motivates both industries to reduce their K/L ratios.
The opposite will happen in India. The shift in production will lead to a surplus of capital and a shortage of labor. Consequence: falling rents, rising wages. K/L will rise in India.
Generalizing: trade will tend to equalize K/L ratios in the two countries. Each country’s industrial structure will shift – U.S. moves away from cloth toward machines; India vice versa
Labor unions will not tolerate falling wages.
But absolute wages will not likely fall. Increasing labor productivity leads to higher wages which tend to mask fall in wages due to shifted industrial structure.
Samuelson: laborers or others who are harmed by opening of trade could be given “hush money” gotten from taxes paid by the general public which benefits from opening of trade. This could be a “fairer” distribution of the gains from trade
Reality (“Trade Adjustment Assistance”):
Massive rent-seeking opportunity – everyone who loses his job will blame foreigners
Research shows no significant benefit
Bureaucrats are the real beneficiaries as usual
We have assumed perfectly mobile labor – all workers in the cloth industry can instantly relocate to the machine industry with no delay and no loss of productivity
Also perfectly mobile capital – all machines formerly used in the cloth industry are equally useful in the machine industry
Suppose equipment used in the cloth industry were useless for machine production, and equipment used for machine production were useless for cloth production
If workers retain perfect mobility they will have an advantage that leads to higher wages
Reality: most workers can be retrained at some cost and are therefore neither perfectly mobile nor perfectly specific
Reality: some capital can be redeployed in new industries; almost all capital has some scrap value
One would expect U.S. to export capital-intensive goods and import labor-intensive goods. Leontieff found the opposite. Some reasons: