Chapter 4:
Who Gains and Who Loses from Trade?

Overview

This chapter has two major purposes. First, it examines the implications for factor income of trade that follows the Heckscher-Ohlin (H-O) theory. Second, it examines the empirical evidence on the Heckscher-Ohlin theory and some of its implications.

The implications of H-O trade for factor incomes follow from the pressures for changes in production levels as a country shifts from no trade to free trade. The export-oriented sector tries to expand production, as the relative price of the exportable good increases. The import-competing sector shrinks its production, as the relative price of the importable good decreases. In the short run, production factors cannot move easily between sectors. Therefore, in the short run, many or all factors employed in the export industry benefit from strong demand for their services and gain income. In the short run, many or all factors employed in the import-competing industry suffer from reduced demand for their services and lose income.

In the long run, the period of time that is emphasized by the Heckscher-Ohlin approach, factors can easily move between sectors. The implications for factor incomes then depends on the factors demanded by the expanding sector relative to the factors released by the contracting industry. According to the H-O theory, the expanding sector is intensive in the country's abundant factor, while the shrinking sector is intensive in the country's scarce factor. In the shift to free trade, there is strong demand for the abundant factor (relative to the small amount released as the import-competing sector shrinks), and there is weak demand for the scarce factor (relative to the large amount released as the import-competing sector shrinks.) The shift to free trade increases the price and income of the abundant factor, and it decreases the price and income of the scarce factor. (The box "A Factor-Ratio Paradox" is difficult for some students, but it does show how full employment can be reached after the shift, as each sector alters the proportions in which it uses factors in response to the change in factor prices.)

Generally, the H-O approach has three major implications for factor incomes.

First, the conclusion about the effect of opening to free trade is an example of the more general Stolper-Samuelson theorem --   the real returns to the factor used intensively in a rising-price industry increase, and the real returns to the factor used intensively in the falling-price industry decline. This theorem applies in a number of situations, if certain conditions apply (including that the country produces both products both before and after the price change, and that the menu of technologies available does not change).

Second, another way to view the broad pattern of the effects of shifting to free trade (or other shifts which change relative product prices) is through the specialized-factor pattern-factors more specialized in the production of exportable products (or rising-price products more generally) tend to gain income, and factors more specialized in the production of import-competing products (or falling-price products more generally) tend to lose income. This pattern applies to both the short and the long run, and especially applies to factors that can only be used in one industry (sector-specific factors).

Third, the H-O approach has a surprising implication for the earnings of a single factor in different countries. The factor price equalization theorem states that free trade that equalizes product prices between countries also equalizes the prices of individual factors between countries. The logic of this can be developed intuitively. With no trade, the price of a factor will be "high" in the country in which it is scarce, and "low" in the country in which it is abundant. The shift to free trade increases the factor's price in the abundant country and decreases its price in the scarce country. Under "ideal" conditions, the factor's prices (in real terms) become equal in different countries. In its impact on differences in factor prices, product trade can be a substitute for international movement of factors.

The chapter then shifts to examine empirical evidence on the Heckscher-Ohlin theory. The box "The Leontief Paradox" summarizes the early tests. The text emphasizes the kinds of information that we need to examine real-world trade patterns-factor endowments and trade patterns, along with knowledge of the factor proportions used in producing different products. It provides evidence on endowments for six factors-physical capital, highly skilled labor, medium-skilled labor, unskilled labor, arable land, and forest land, and it discusses endowments of other natural resources. The examination of the U.S. pattern of international trade suggests that some of its trade seems consistent with the H-O predictions, but some also does not seem consistent. In general, trade patterns for the United States and other countries match the H-O theory reasonably well but not perfectly.

According to the H-O approach and the Stolper-Samuelson theorem, the factors that gain from free trade are those that are used intensively in export-oriented production, while the factors that lose are those used intensively in import-competing production. The chapter presents evidence on the factor content of export and import-competing production in the United States and Canada, along with brief comments about other countries.

Finally, the chapter provides evidence on international factor price equalization. While it clearly does not hold perfectly, even if we define factors carefully, we do see tendencies toward factor price equalization. Most obviously, as countries in Asia have integrated themselves into world trade, real wages in these countries have increased rapidly and approach the real wages earned by comparably skilled workers in industrialized countries.

The box "U.S. Jobs and Foreign Trade" provides a survey of the effects of international trade that focuses on employment. While this is not the most valid way to examine the effects of trade (as noted at the end of the box), it is the way that much of the debate actually occurs politically. The box shows that even on these terms the net effects on jobs are not clear, because reducing imports also tends to reduce exports.

The chapter's summary pulls together the answers that have been developed in Chapters 2-4 to the four key questions about trade presented at the beginning of Chapter 2.

Key Terms

Factor price equalization theorem: Under certain assumptions free trade will equalize not only commodity prices between countries but also factor prices, so that all laborers will earn the same wage rate and all units of land will earn the same rental return in both countries regardless of the factor supplies or the demand patterns in the two countries.

Factor specialization: The degree of concentration of a factor in the production of a commodity or group of commodities.

Neutral factor: A factor which accounts for the same share of the value of output in all commodity lines.

Magnification effect: The principle that a factor's price changes by a greater percentage than the change in the commodity price that caused it.

Stolper Samuelson theorem: Under certain assumptions, moving from no trade to free trade unambiguously raises the returns to the factor used intensively in the rising price industry and lowers the returns to the factor used intensively in the falling price industry, regardless of which goods the owners of the factors prefer to consume.

Warm up Questions

True or False? Explain
1. T / F The Leontief Paradox may be resolved by using more disaggregated definitions of factors of production.
2. T / F The Stolper Samuelson theorem says that trade will cause the owners of the abundant factor to receive lower real incomes while the real incomes received by owners of the scarce factor will rise.
3. T / F Nobel prizes are not given to dead economists.
4. T / F Factor prices will not be equalized by trade if technologies are not the same in different countries.
5. T / F Unskilled workers in the United States should be more opposed to free trade than skilled workers in the United States.

Multiple Choice

1. Studies of U.S. trade and its effects on employment of U.S. labor show that, on average:

A. Trade has no effect on total employment.
B. Replacing imports (e.g. through protection from foreign competition) saved (or created) more jobs than an equivalent expansion of exports.
C. Expanding exports creates more jobs than an equivalent amount of import substitution.
D. Foreign competition has clearly raised the unemployment rate, particularly in the 1980s.

2. After trade opens up, in the short run:

A. All groups tied to the declining sectors lose.
B. Only factors more intensively used in the declining sectors lose.
C. Only factors less intensively used in the declining sectors lose.
D. Only the most abundant factor in the country loses.

3. Mexico is an unskilled labor abundant country, while the United States is a skilled labor abundant country. With the opening of trade you would expect that in the long run wages for unskilled workers:

A. Decline in both countries.
B. Decline in the United States and rise in Mexico.
C. Rise in the United States and decline in Mexico.
D. Rise in both countries.

4. Which of the following statements is false?

A. Consumption patterns do not matter for welfare gains or losses of neutral factors.
B. Consumption patterns do affect the size of the gains or losses to all factors.
C. Consumption patterns do not affect the direction of gains or losses for the most specialized factors.
D. Consumption patterns do not matter for the welfare gains or losses of a nation as a whole.

5. Factor price equalization will not hold if.

A. Factors are immobile between sectors of the economy.
B. Factors have different productivities in different countries.
C. Countries put up barriers to free trade.
D. All of the above.

Problems

1 . Recall our hypothetical trade model: Leinster is a labor abundant country and Saxony is a land abundant country; telephones are labor intensive goods and bread is a land intensive good. Assume that free trade prevails between the two countries.

a. What happens to wages earned by workers in Leinster in the short run? In the long ran?
b. What happens to wages earned by workers in Saxony in the short run? In the long run?
c. According to the factor price equalization theorem, will labor wages in Leinster equal land rents in Leinster, or will Leinster wages equal Saxony wages?

2. Given the implications of trade Inodels for factor prices, how would you explain an observation that, in the late 1980s, the hourly manufacturing wage in West Germany was $13.44 while the wage was only $7.46 in the United Kingdom?

3. Consider an economy producing capital intensive computers and land intensive wheat. Labor is employed to produce both goods. If free trade raises the price of computers relative to wheat, who would gain and who would lose in each of the following two cases:

a. Factors are perfectly immobile between the two sectors.
b. Factors are perfectly mobile between the two sectors.

4. a. Have America's existing import barriers raised or lowered the demand for U.S.labor? Explain.
b. Would a uniform percentage cut in U.S. imports raise or lower the demand for U.S. labor? Explain.

5. You are given the following cost data for France, where they have nothing but capital and labor and make nothing but bread and wine:

a. Is bread making more capital intensive than wine making or vice versa? Explain.
b. Suppose trade opens and the price of wine rises while the price of bread falls. If capital and labor were completely immobile between bread making and wine making, who in France would gain from the shift in prices? Who would lose? (Consider the four groups of bread capitalists, bread laborers, wine capitalists, and wine laborers.)
c. Which group of consumers will rejoice with the winemakers in the situation presented in question 5b? Which group of consumers will commiserate with the breadmakers?
 

6. Suppose that a new isolationist government in Leinster decides to shut off the country's imports of land intensive bread, preferring to produce its own food instead of making labor intensive telephones for export. After trade is shut off, bread becomes 14 percent more expensive relative to telephones (i.e., telephones become 14 percent cheaper relative to bread).

a. Over the long run how greatly, and in what direction, will the isolation change Leinsterian laborer's real wage incomes?
b. Over the long run how greatly, and in what direction, will the isolation change Leinsterian landlords' real rental income?
 

Discussion Topics

1. What do you think would happen to factor prices internationally if an energy crisis tripled the cost of shipping goods around the globe?

2. Policymakers today are concerned about retraining unemployed workers. Try to make a case for such programs as a means of increasing public support for free trade.

Answers

True/False

1. True. 2. False: just the reverse is the case, with owners of scarce factors seeing their incomes fall. 3. True: that's why Joan Robinson will never receive the prize for her work on imperfect competition. Proof•it is an imperfect world. 4. True. 5. True: unskilled labor is used relatively more in the import-competing industries in the United States.

Multiple Choice

1. C. 2. A. 3. B. 4. A. 5. D.

Problems

1. When trade opens up, the price of bread falls in Leinster and rises in Saxony. At the same time, the price of telephones rises in Leinster and falls in Saxony.

a. In the short run Leinster's bread workers see their wages fall, while telephone workers see their wages rise. In the long run all workers see their wages rise as labor moves out of the declining bread industry and into the laborintensive telephone industry.

b. In the short run Saxony's bread workers see their wages rise, while telephone workers see their wages fall. In the long run all workers see their wages fall as labor is released from the labor-intensive telephone industry but its not needed in great amounts in the landintensive bread industry.

c. If the factor price equalization theorem holds, the wages of the abundant workers in