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International trade and investment summary 2
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International trade and investment summary Krugman, P.R., Obstfeld, M. and Melitz, M.J. (2018), International Trade. Theory and Policy, 11th edition Week 2
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CH 4 KrugmanWhy international trade has strong effects on the distribution of income:
1. Resources cannot move immediately or without cost from one industry to another—a
short-run consequence of trade.
2. Industries differ in the factors of production they demand. A shift in the mix of goods
a country produces will ordinarily reduce the demand for some factors of production,
while raising the demand for others—a long-run consequence of trade.
Specific factors model allows for the existence of factors of production besides labor.
Whereas labor is a mobile factor that can move between sectors, these other factors are
assumed to be specific. That is, they can be used only in the production of particular goods.
→ Assumes that each of the specific factors, capital and land, can be used in only
one sector.
Production possibility frontier is a straight line because the opportunity cost of cloth in terms
of food is constant. In the specific factors model, however, the addition of other factors of
production changes the shape of the production possibility frontier PP to a curve. The
curvature of PP reflects diminishing returns to labor in each sector; these diminishing returns
are the crucial difference between the specific factors and the Ricardian models.
The wage rate w must be the same in both sectors because of the assumption that labor is
freely mobile between sectors. That is, because labor is a mobile factor, it will move from the
low-wage sector to the high-wage sector until wages are equalized. The wage rate, in turn, is
determined by the requirement that total labor demand (total employment) equals total labor
supply.
Changes in the overall price level have no real effects, that is, do not change any physical
quantities in the economy. Only changes in relative prices affect welfare or the allocation of
resources.
The effect of a relative price change on the distribution of income:
- The factor specific to the sector whose relative price increases is definitely better off.
- The factor specific to the sector whose relative price decreases is definitely worse off.
- The change in welfare for the mobile factor is ambiguous.
When opening up to trade, an economy exports the good whose relative price has increased
and imports the good whose relative price has decreased.
Trade benefits the factor specific to the export sector of each country but hurts the factor
specific to the import-competing sectors, with ambiguous effects on mobile factors.
Budget constraint for a trading economy:
1. Slope of the budget constraint is minus PC>PF, the relative price of cloth. The
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