Resources, Comparative Advantage and Income Distribution

December 5, 2017 General Studies

Previously, the Arcadian Model presents that both the country and its individuals are made better-off by trade. On the other hand, this is not the case in the real world so this discussion would highlight the actual effects of trade to the distribution of income to the individual. Distribution of income There are two prevalent reasons as to why international trade has brought significant effects on the distribution of income: A. Resources cannot move immediately or without cost from one industry to another; and B. Industries differ in the factors of production they demand.

The first reason shows the short-run disadvantage of trade while the second one presents the long-run consequence in he sense that changing the combinations of products that an economy produces will certainly reduce the need for some of the factors of production in the country while raising the need for others. This being explained, we can now say that a more realistic model would be needed to aid in our study of how income distribution can be affected by trade. Specific Factors Model l. ASSUMPTIONS This model makes it possible for trade to affect the income distribution with the assumptions that: 1 .

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There are two goods produced in an economy. 2. There are other factors of production besides from labor (L), such as Land (T) and UAPITA (K). 3. Perfect competition prevails in the market, which assures that all participants have equal chances. 4. One of the two goods can only be produced using capital and labor, while the other can only be produced using land and labor. 5. It is given that labor is a mobile factor that can move to different sectors, while land and capital are specific factors that can be only used in a production of one good.

Now that we have determined the assumptions that this model would revolve around, it is time to delve further and determine the level of production that a country should utilize. A production function will help in telling us how much output can be produced in a given set of inputs. II. PRODUCTION POSSIBILITIES As mentioned above, it is assumed that the economy produces two good so it is important to determine how much of both goods should be produced in an economy.

Let us denote these goods as A and B respectively. It is Just important to note that the ideas of both the marginal product of labor and diminishing returns would be central in the discussion of this topic. Firstly, we must take into consideration that only labor can be used in producing goods A and B. Looking back at the production unction’s of both goods, we can see that the input of labor for either good would determine the size of the soon-to-be output.

Therefore, the marginal product of labor expresses the change that will occur by adding a unit of labor. However, diminishing returns will take place once labor is increased without increasing the other factor of production which may be land and capital. It simply means that?in the concept of producing good A, which requires both labor and capital?adding one worker to the production process (without increasing the amount of capital) means that each worker has less capital to work with.

These relationships can be better explained using graphical representations that show the production function and the marginal product of labor for both goods, thus, deriving the production possibilities frontier of the goods in the country. Ill. PRICES, WAGES, AND LABOR ALLOCATION Consequently, after finding the means to determine how much of both goods to produce, we must now ascertain how much labor can be employed in each sector. Therefore, we need to take in consideration the supply and demand in the labor market.

Two things are used to determine the demand for labor, which is the price of output and the wage rate. These will aid in determining the sector’s employment and level of output. Given the production of both goods in the economy, for us to find the level of labor that is profit-maximizing, labor demand should be up to the point where the wage of good A equals good B. Provided that wage for both goods is equal to each good’s respective marginal product of labor multiplied by the price of one unit of good.

Moreover, it is of importance that the wage rate is similar in both sectors, since we have already stated before that labor is a mobile factor. In simple terms, the equilibrium between the two sectors producing both goods would only be met once the wage in these sectors become equal. Once that happens, we can now determine the allocation of labor needed for each good in the economy. Having established that wage rate will equal for the demand for labor of both goods, we can now determine what happens when the prices for good A and B change, which we will break into two parts: A.

An equal-proportional change in prices Assume that the price of goods A and B changes with similar magnitudes, no real changes occur as the allocation of labor remains the same although the wage rate hinges in the same proportion as the prices, and the real incomes of capital owners and landowners will remain the same. Meanwhile, the real wage of the laborers will not change since the price and the wage rate changed by the same magnitude. An example would be a decrease of 10% a graphical representation of the demand of labor for both goods will both shift downwards.

Not changing the labor allocation and decreasing the wage rate by 10%. B. Change in relative prices Assume that only one between the prices of goods A and B changes, to see what will happen, let us imagine that the price of good A decreases by 10%. Consequently, a replica representation will show that the graph for the labor demand for good A will shift downwards, which will cause for the labor allocation to be more allocated to good B and the wage rate will decrease ambiguously since the wage change is not proportional to the price change.

Given that we assumed that good A is produced using capital and labor only, owners would be worse-off because we mentioned that labor allocation is more concentrated to good B; therefore, landowners would be better-off. International Trade in a Specific Factors Model Moving on, we now want to find out the link between changes in relative price with international trade. It is evident that trade between countries would only be feasible once a country adjust to the world relative price that is dissimilar from the relative price when a country is not trading.

This difference in price is caused by the difference in in technology as stated by the Arcadian model or that the countries would differ in their factors of production. Consequently, when a country or an economy is open to trade the relative price of a good is decided by the relative supply and demand for the world, which will correspond to a higher relative price and a lower one if the economy does not trade. If the economy is open, then the economy is more likely to produce more of a particular good while less of the other.

As a result, the economy exports a particular good while importing the other. Income Distribution and Gains from Trade Having known how resources and technology determine production possibilities; how the relative price of a good determines what to produce; how real incomes of different factors of production changes in the relative price of a good; and how relative prices and the economies’ response to these changes is affected by trade, we could now determine whether a country would gain or loss from international trade.

Trading increases the relative price of a good, so trade benefits the factor that is specific to the export sector of each country, but hurts the factor that is specific to the import-competing sectors with ambiguous effects on mobile factors. Finding out who gains or losses is subjective, but looking on how those who gain can compensate those who lose then trade is potentially a source of gain for everyone. This gain can be expressed using the budget constraint for a trading economy so that a unit of a particular good can be exchanged for extra units of another.

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