SFM Model: Analyzing Global Trade Impacts on Economy & Factor Payments

1. Globalization, Growth, and Trade Lectures 13-14: Specific Factors Model (SFM)

2. Overview - Today • Motivation: Bringing ‘structure’ of economy into trade discussion, a quick look at global export shares and comparative advantage • Overview of the Specific Factors Model (SFM) • Analytical pieces of the SFM • Production function • Production possibility frontier • Production function and implied factor returns • 4 quadrant model (labor, 2 production functions, possibility frontier) • Trade, production and factor payments in the SFM • Analysis: winners and losers from global market shocks

3. Regional export shares by sector

4. Primary product export shares • Latin Am: 50% avg., but 85% for Andean countries • 60% of Mercosur inc. Bolivia and Chile; • Over 65%: Argentina, Belize, Bolivia, Chile, Colombia, Nicaragua, Panama, Paraguay, Peru, Uruguay, Venezuela • Under 40% - Costa Rica and Mexico • Comparative advantage of most of LA is clear • S.S. Africa: most countries are mainly primary exporters • 4 countries with <70% (Togo, Senegal, South Africa, Mauritius) • 6 with 70-80% share (Guinea, Kenya, Madagascar, Niger, Zambia, Zimbabwe) • The other 25 have > 80% primary export share

5. Comparative Advantage Comparisons • If export shares => comp advantage, then most of L Am & Africa have comparative advantage in primary products. • What implications might this have for development? • Why does it matter to poverty? • Recall that Yh = wLh + rKh: how would expanding primary products shape household incomes? What does your answer depend on? • Why might you be concerned about the poverty implications of comparative advantage in primary products versus manufacturing? • We can get more on this once we dig further into our next trade model

6. Political economy implications • HO-SS predicts aggregate gains from trade, but also losses for some groups --> Functional (self-interest) basis for some positions on trade: • Owners of abundant factors in favor • Owners of scarce factors opposed • Examples?

7. Overview of Specific Factors Model (SFM) • 2 good model (like H-O) • But capital (or natural resource) is specific to sectors (cannot be moved to other sector) • Does this make sense? • Can a coffee farm become a clothing factory in short term? • In long term? • In SFM, only labor is mobile between sectors • Use SFM to study how changes in trade patterns, FDI, and technology affect economic structure and incomes when factor-specificity limits adjustment • Helps us to see winners and losers from trade in a slightly different way.

8. Production function – 1 sector • Factors of production • Production function • Diminishing returns • VMP and factor payments

9. Production Function Rice (tons) ƒx(L, K) 28 27 25 20 Labor days 0 10 20 30 40 • Constant returns to scale in (L,K), so dim. returns toL when quantity of K is fixed

10. Production Function (more K -> more rice) ƒx(L, K+) Rice (tons) ƒx(L, K) 28 27 25 20 Labor days 0 10 20 30 40 • Constant returns to scale in (L,K), so dim. returns toL when quantity of K is fixed (irrigated paddy) 9

11. Calculating Factor Returns X = (w/px)Lx + πx X X0 0 slope = w/px ƒx(K,L) Revenue = costs X*px = w*Lx + rx*Kx πx or: X = (w/px)Lx + πxwhere: πx = (rx/px)*Kx Lx0 Lx • Assume: wage = value of labor’s marginal product• Return on labor (= wage) = slope of tangent to function • Return on stock of sector-specific capital is height 0πx = (rx/px)Kx

12. (Derivation of factor returns) • Total revenue of the firm: pxX = wL + rxKx • By assumption, the value of output is fully divided between workers and capital owners • Dividing both sides by px: X = (w/px)L + (r/px)Kx = (w/px)L + πx • Note: w/px is known as the product wage in sector X • Distribution between L and K: X – (w/px)L = πx • Higher wage (steeper slope on w/px) implies lower profit share. Flatter slope implies higher profit share

13. The specific factors model • Assume 2 goods, X and M • Each sector uses specific capital, Kx, Km--> prod’n fns yj = ƒj(L, Kj), j = X, M • Labor is ‘mobile’ (can be reallocated) between X and M production • Total labor force is fixed and fully employed: L = Lx + Lm • In equilibrium, same wage offered in both sectors • For given Kxand Km, when labor is fully employed, can only increase output (create jobs) in one industry by reducing output (destroying jobs) in the other

14. General Equilibrium – Supply Side Production function M M Prod’n Poss. Frontier, Maps total production possible given PFs and labor ƒm(Lm,Km) 0 X L 50 Production function x ƒx(Lx,Kx) Labor constraint 45o 50 L

15. Autarky (no trade) M • uA MA pA • • XA Lm 0 X L • Lx LA 45o L

16. From Autarky to Trade p* > pA • M uT MT < MA LMT < LMA … uT = uA LT = LA • uA MA pA • MT p* • • • • XA Lm 0 XT X L • Lx LA • LT L

17. Trade, income, distribution in SFM • Integration with world economy raises aggregate real income & cons. welfare • Structure of production and labor allocation change in predictable ways • What happens to returns to specific factors? (hint: Stolper-Samuelson - see notes from Week 1) • What happens to the real wage?

18. Aggregate Income M uT uA pA pT 0 YA YT X L LA Compare old and new incomes at constant prices! LT 45o L

19. (Aggregate income change) • YT = aggregate income from production of the combination (XT, MT) valued at world prices pT, measured in terms of good X (the value of X that could be bought with that much income) • Compare: YA = aggregate income from production of the combination (XA, MA), valued at world prices pT, measured in terms of good X • YT > YAsays the economy is better off in aggregate

20. Changes in factor payments (w/pM)T M pA slope = (w/pM)A pT 0 X L LA LT 45o L

21. (Changes in factor payments) • Moving from autarky to trade raises X output and employment, lowers M output and employment • Demand for KXrises; πXT > πXA • Demand for KMfalls; πMT > πMA • Demand for L in M falls; with KM fixed , law of diminishing returns says thatproductivity of remaining workers rises, so (w/pM)A < (w/pM)T • Demand for L in X rises; with KX fixed,(w/pX)A > (w/pX)T • Are workers better off or worse off?

22. Comparative Advantage in Agriculture

23. Comparative Advantage in Agriculture

24. Comparative Advantage in Manufacturing

25. Comparative Advantage in Manufacturing

26. Distributional & poverty effects • Real specific factor returns follow own prices: for a rise in px/pm, πxwill rise, πmwill fall • Real wage change is indeterminate: • Wage rises rel. to pm, but falls rel. to px • H’hold welfare: aggregate has risen, but • Gains for owners of capital in X • Losses for owners of capital in M • Workers’ welfare change is ambiguous

27. Discussion • If we have data on asset ownership & cons. patterns, can compute changes in Rh and poverty for groups • Poverty effects depend on distribution of assets as well as on changes in payments such as wages and rents • Notice that we have assumed labor is mobile between sectors. Realistic? What if it is not? • SFM vs H-O: which is more realistic? When? • What about more complex models, for example with some endogenous product prices (nontradables?) • See next class…