Question

10. Use the specific factor model to answer the following question. Suppose Country Z produces two goods: Wood and Manufactures. Labour is used as input for both goods. Forests are the specific factor used for wood production while capital is the specific factor used for manufactures production. Country X is a traditional exporter of Wood. The government decides to introduce a tariff on imports of manufactured goods, leading to a price increase for Manufactures. Draw a graph to show how this will affect production and wages. What do you think is the reaction of the forests owners to such a tariff?

Answer 1

Q10) The specific factor model assumes that the country Z produces two goods, woods and manufactures, Production of good one i.e. wood uses labour as fixed input and specific factor forests. Production of good two i.e. manufactures uses labour as fixed input and specific factor capital. It is assumed that both country Z and country X uses different amount of specific factors , causing their PPF's to differ, and it would potentially lead to trade.

Two goods: Country X is producer of wood, Country Z is producer of manufactures, Wood is specific to and requires labour and forests, manufactures are specific to and requires labour and capital, wood is imported from country X, manufactures is exported to country X.

Now, in a two good specific factor model, if the price of one good increases, and this change in price is due to trade liberalization, then the industry whose prices increases is the export sector. Now if govt introduces a tariff on the imports of manufactured goods in country Z, it will causes an increase in the price of manufactures, which implies that manufactures is the exports sector. Now, these higher export prices will initially increase the profits in the manufactures sector since the wages and rent take some time to adjust. The value of the marginal products in manufactures export will increase above the current wage and this will make the firms to hire a greater number of workers and increase the output. However, the increased demand for labour, wll increase the wages, so the importing sector i.e. wood will also have to increase their wages in order to prevent losing their workers. The higher wages will lead to expansion of output in export i.e. manufactures sector, and there is a reduction in the output in the import i.e. wood sector.

In the import i.e. wood industry, lower profits and higher wages will combine to reduce the return to the capital in the wood sector. However, in the export i.e. manufactures sector, higher output and greater prices will help to increase he return to capital in that sector. So, the real return to capital in the manufactures industry, will increase , real return to forests in wood industry will fall, and the real wages to labour in both wood and manufactures industry, will increase with respect to purchase of wood and decrease with respect to purchase of manufactures.

So, due to the free trade, owners of capital in manufactures industry will benefit from the free trade, while owners of forest in the import-competing industry of wood will lose from the free trade. Labour which is freely mobile between the two industries may gain or lose, depending on the real wage in terms of manufactures increases while real wage in terms of wood falls. Those individuals who have a relatively greater demand for manufactures will suffer a wefare loss, and the individuals who have a greater demand for wood will experience a welfare gain.

So, the forest owners won't be happy because of the tariff as their real return decreases, production decreases, wages to labour increase.

Capital owners will be happy because of the tariff as their real return increases, production expands and get higher prices.

Take a look at fig 1 and 2.

L_M = labour demand in manufactures, L_W = labour demand in wood sector, after tariff, L_M increases and L_W goes down, the output of manufactures Q_M increases while output of wood Q_w falls, also wage increases from w to w'.

The equilibrium moves from E to E' and forest owners of country Z's income reduces.