Iffects of International Trade Between Two Factor Economies

Having outlined the production structure of a two-factor economy, we can now look at what happens when two such economies. Home and Foreign, trade. As always, Home and Foreign are similar along many dimensions. They have the same tastes and therefore have

4The biased effect of resource changes on production was pointed out in a paper by the Polish economist T. M. Rybczynski, "Factor Endowments and Relative Commodity Prices," Eamomicu 22 (1955), pp. 336-341. It is therefore known as the Rybczynski effect.

identical relative demands for food and cloth when faced with the same relative price of the two goods. They also have the same technology: A given amount of land and labor yields the same output of either cloth or food in the two countries. The only difference between the countries is in their resources: Home has a higher ratio of labor to land than Foreign does.

Relative Prices and the Pattern of Trade

Since Home has a higher ratio of labor to land than Foreign, Home is labor-abundant and Foreign is land-abundant. Note that abundance is defined in terms of a ratio and not in absolute quantities. If America has 80 million workers and 200 million acres (a labor-to-land ratio of one-to-two-and-a-half), while Britain has 20 million workers and 20 million acres (a labor-to-land ratio of one-to-one) we consider Britain to be labor-abundant even though it has less total labor than America. "Abundance" is always defined in relative terms, by comparing the ratio of labor to land in the two countries, so that no country is abundant in everything.

Since cloth is the labor-intensive good, Home's production possibility frontier relative to Foreign's is shifted out more in the direction of cloth than in the direction of food. Thus, other things equal, Home tends to produce a higher ratio of cloth to food.

Because trade leads to a convergence of relative prices, one of the other things that will be equal is the price of cloth relative to food. Because the countries differ in their factor abundances, however, for any given ratio of the price of cloth to that of food Home will produce a higher ratio of cloth to food than Foreign will: Home will have a larger relative supply of cloth. Home's relative supply curve, then, lies to the right of Foreign's.

The relative supply schedules of Home (RS) and Foreign (RS*) are illustrated in Figure 4-8. The relative demand curve, which we have assumed to be the same for both countries, is shown as RD. If there were no international trade, the equilibrium for Home would be at point 1, the equilibrium for Foreign at point 3. That is, in the absence of trade the relative price of cloth would be lower in Home than in Foreign.

When Home and Foreign trade with each other, their relative prices converge. The relative price of cloth rises in Home and declines in Foreign, and a new world relative price of cloth is established at a point somewhere between the pretrade relative prices, say at point 2. In Home, the rise in the relative price of cloth leads to a rise in the production of cloth and a decline in relative consumption, so Home becomes an exporter of cloth and an importer of food. Conversely, the decline in the relative price of cloth in Foreign leads it to become an importer of cloth and an exporter of food.

To sum up what we have learned about the pattern of trade; Home has a higher ratio of labor to land than Foreign; that is, Home is abundant in labor and Foreign is abundant in land. Cloth production uses a higher ratio of labor to land in its production than food; that is, cloth is labor-intensive and food is land-intensive. Home, the labor-abundant country, exports cloth, the labor-intensive good; Foreign, the land-abundant country, exports food, the land-intensive good. The general statement of the result is: Countries tend to export goods whose production is intensive in factors with which they are abundantly endowed.

Trade and the Distribution of Income

Trade produces a convergence of relative prices. Changes in relative prices, in turn, have strong effects on the relative earnings of labor and land, A rise in the price of cloth raises the to a Convergence of Relative Prices

In the absence of trade, Home's equilibrium would be at point 11 where domestic relative supply RS intersects the relative demand curve RD. Similarly, Foreign's equilibrium would be at point 3. Trade leads to a world relative price that lies between the pretrade prices, e.g.( at point 2.

Relative price of cloth, PC/PF

Relative quantity purchasing power of labor in terms of both goods while lowering the purchasing power of land in terms of both goods, A rise in the price of food has the reverse effect. Thus international trade has a powerful effect on income distribution. In Home, where the relative price of cloth rises, people who get their income from labor gain from trade but those who derive their income from land are made worse off. In Foreign, where the relative price of cloth falls, the opposite happens: Laborers are made worse off and landowners are made better off.

The resource of which a country has a relatively large supply (labor in Home, land in Foreign) is the abundant factor in that country, and the resource of which it has a relatively small supply (land in Home, labor in Foreign) is the scarce factor. The general conclusion about the income distribution effects of international trade is: Owners of a country's abundant factors gain from trade, but owners of a country's scarce factors lose.

This conclusion is similar to the one reached in our analysis of the case of specific factors. There we found that factors of production that are "stuck" in an import-competing industry lose from the opening of trade. Here we find that factors of production that are used intensively by the import-competing industry are hurt by the opening of trade. As a practical matter, however, there is an important difference between these two views. The specificity of factors to particular industries is often only a temporary problem: Garment makers cannot become computer manufacturers overnight, but given time the U.S. economy can shift its manufacturing employment from declining sectors to expanding ones. Thus income distribution effects that arise because labor and other factors of production are immobile represent a temporary, transitional problem (which is not to say that such effects are not painful to those who lose). In contrast, effects of trade on the distribution of income among land, labor, and capital are more or less permanent.

We will see shortly that the trade pattern of the United States suggests that compared with the rest of the world the United States is abundantly endowed with highly skilled labor and that low-skilled labor is correspondingly scarce. This means that international trade tends to make low-skilled workers in the United States worse off—not just temporarily, but on a sustained basis. The negative effect of trade on low-skilled workers poses a persistent political problem. Industries that use low-skilled labor intensively, such as apparel and shoes, consistently demand protection from foreign competition, and their demands attract considerable sympathy because low-skilled workers are relatively badly off to begin with.

The distinction between income distribution effects due to immobility and those due to differences in factor intensity also reveals that there is frequently a conflict between short-term and long-term interests in trade. Consider a highly skilled U.S. worker who is employed in an industry that is intensive in low-skilled labor. Her short-term interest is to restrict international trade, because she cannot instantly shift jobs. Over the long term, however, she would be better off with free trade, which will raise the income of skilled workers generally.

Factor Price Equalization

In the absence of trade, labor would earn less in Home than in Foreign, and land would earn more. Without trade, labor-abundant Home would have a lower relative price of cloth than land-abundant Foreign, and the difference in relative prices of goods implies an even larger difference in the relative prices of factors.

When Home and Foreign trade, the relative prices of goods converge. This convergence, in turn, causes convergence of the relative prices of land and labor. Thus there is clearly a tendency toward equalization of factor prices. How far does this tendency go?

The surprising answer is that in the model the tendency goes all the way. International trade leads to complete equalization of factor prices. Although Home has a higher ratio of labor to land than Foreign, once they trade with each other the wage rate and the rent on land are the same in both countries. To see this, refer back to Figure 4-3, which shows that given the prices of cloth and food we can determine the wage rate and the rental rate without reference to the supplies of land and labor. If Home and Foreign face the same relative prices of cloth and food, they will also have the same factor prices.

To understand how this equalization occurs, we have to realize that when Home and Foreign trade with each other more is happening than a simple exchange of goods. In an indirect way the two countries are in effect trading factors of production. Home lets Foreign have the use of some of its abundant labor, not by selling the labor directly but by trading goods produced with a high ratio of labor to land for goods produced with a low labor-land ratio. The goods that Home sells require more labor to produce than the goods it receives in return; that is, more labor is embodied in Home's exports than in its imports. Thus Home exports its labor, embodied in its labor-intensive exports. Conversely, Foreign's exports embody more land than its imports, thus Foreign is indirectly exporting its land. When viewed this way, it is not surprising that trade leads to equalization of the two countries' factor prices.

Although this view of trade is simple and appealing, there is a major problem: In the real world factor prices are not equalized. For example, there is an extremely wide range of

Table 4-1 Comparative Intei

Rates (United States = 100)

Country

Hourly compensation of production workers, 2000

United States Germany Japan Spain

South Korea Portugal Mexico Sri Lanka*

0 0

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