Outline for the Specific Factors Model

As the compliance of Final Exam in International Economics

Supervised by : Mr. Ferry Prasetyo

By :
Fery Fachrudin
M. Zikril Hakim
Bagus Andriadi

Economics Development Program

Faculty of Economics and Business
Brawijaya University
2012
Specific Factors Model
The specific factor (SF) model was originally discussed by Jacob Viner and it is a variant
of the Ricardian model. Hence the model is sometimes referred to as the Ricardo-Viner model.
The model was later developed and formalized mathematically by Ronald Jones (1971) and
Michael Mussa (1974). Jones referred to it as the 2 good-3 factor model. Mussa developed a
simple graphical depiction of the equilibrium which can be used to portray some of the model
results

Assumptions of the Model

Here is the assumption of specific factor model:
 Two goods: An economy can produce two goods,
 Manufactures QM and Food, QF
 Two Countries: Home and Foreign
 Three Factors of Production:
o Production of Manufacturing requires Labor L and Capital K
 QM = QM (K, LM) (1)
o Production of Food requires Labor L and Land T
 QF = QF (T, LF) (2)
o Labor is perfectly mobile between the two sectors.
 LM + LF = L (3) (full employment condition)
o Capital and Land and immobile between the sectors –are sector specific
o Supply of the Three inputs are given and fixed
 Technology
o Constant Returns to Scale (CRS) production functions:
 Perfect competition prevails in all markets.
 The two countries differ only in their factor endowments (same tastes, same tech)

Prices, Wages, and Labor Allocation

“How much labor will be employed in each sector?”
To answer the question above we need to look at supply and demand in the labor market.
Demand for labor:
In each sector, profit-maximizing employers will demand labor up to the point where the
value produced by an additional person-hour equals the cost of employing that hour.

The demand curve for labor in the manufacturing sector can be written:
MPLM x PM = W (4)

The demand curve for labor in the food sector can be written:
MPLF x PF = W (5)

The wage rate must be the same in both sectors, because of the assumption that labor is
freely mobile between sectors.

The wage rate is determined by the requirement that total labor demand equal total labor
supply:
LM + LF = L (6)
 The Specific Factors Model
Figure 3-4: The Allocation of Labor
Wage rate, W
Wage rate, W

PF X MPLF
(Demand curve
1 for labor in food)
W1
PM X MPLM
(Demand curve for labor in
manufacturing)
Labor used in Labor used
manufactures, LM in food, LF
L1M L1 F
Total labor supply, L
Copyright © 2003 Pearson Education, Inc. Slide 3-16

The graph above tells us about how a country can achieve maximum allocation of labor. The
horizontal line is the total labor and vertical line is the labor payment, wage rate. If the supply
and demand curve for labor intersect, than it is means it is maximum point for labor allocation.

International Trade in the Specific Factors Model

Let’s assume Home is capital abundant and Foreign is land abundant. They have an equal
amount of labor endowment.

Trade, Relative Prices and Patterns of Trade

Since compared to Foreign, Home is capital abundant the pre-trade relative price of
manufactures in Home is lower than the pre-trade relative price in Foreign.
• International trade leads to a convergence of relative prices.
• Foreign will export Food and Home will export manufacturing
 QF

U2
A
U1
B

Slope=-PM/PF

QM

Gains from Trade

In absence of international trade, the economy produces and consumes at point A. With
trade the economy produces at point B and consumes at point C. The rice of utility from U1 to U2
is a measure of the gains from trade for the economy.

Single Firm Equilibrium in the Specific Factor Model

In this context, a firm will maximize its profit when it produces a level of output such that
the wage it must pay to workers is equal to the value of the marginal product at the chosen level
of output. This is written in equation form for a textile firm as follows, w = PT MPT
The left-hand-side of the equation represents the hourly wage the firm pays its workers.
The right-hand-side is the value of the marginal product. It consists of the product of the market
price of output (PT) and the marginal product of production (MPT).
To see why this condition will hold when the firm maximizes profit, we will graph these
expressions on the adjoining diagram which depicts
the value of marginal product line for a
representative textile firm, VMPT = PTMPT, and the
market wage rate, wT, with respect to the labor
supply.
 The wage is assumed exogenous to each firm and is independent of the labor supply. Hence
it is drawn as a horizontal line at the level of the wage, wT(1)
The value of marginal product is a decreasing function of labor. This means that at higher
levels of labor usage, each additional unit of labor applied to production adds fewer units of
output. The intuition for this is straightforward. Imagine more and more workers being assigned
to use the same machine in a production process. Each additional worker may help in the
production process and add output (thus MP >0), but as more and more are added, overcrowding
will set in and each person will find less and less to do that is helpful. Thus, the marginal product
will fall. Since we draw the value of marginal product line under the assumption that there is a
fixed amount of specific capital in the industry, the same overcrowding argument applies at the
larger industry scale.
The position of the VMP line is dependent on the market price and the amount of specific
capital, both assumed to be exogenous. If the price of the product rises (falls), the VMP line
shifts upwards (downwards). The same applies for changes in the amount of specific capital. If
the amount of specific capital in the industry were to rise (fall), the VMP line would shift
upwards (downwards).
The profit maximizing choice of labor input by the industry is determined at level LE on the
horizontal axis where the wage wT is equal to the value of the marginal product VMPT at E. To
see why, consider what it would mean if the industry chose a different labor input, say L1. At L1,
VMPL1 > wT. This says that the additional revenue earned by expanding labor input by one unit
exceeds the additional cost of adding one more unit of labor. Thus, adding one more unit of labor
must raise profit which means that L1 cannot be the profit maximizing choice - it must lie to the
right of L1. Next consider labor input L2. At L2, VMPL2 < wT. This says that the additional
revenue earned by expanding labor input by one unit is less than the cost of adding one more unit
of labor. Thus, adding one more unit of labor must lower profit which means that L2 cannot be
the profit maximizing choice - it must lie to the left of L2. Finally, consider labor input LE. At LE,
VMPLE = wT. This says that the additional revenue earned by expanding labor input by one unit
equals the additional cost of adding one more unit of labor. Thus, adding one more unit of labor
has no effect upon profit, which means that LE must be the profit maximizing choice.
Two Firm Equilibrium in the Specific Factor Model
The economy consists of two industries, textiles and steel, each of which is choosing
labor input so as to maximize profit. Thus when both industries operate and both maximize
profit, wT = VMPT (1) for textiles, and wS = VMPS (2) for steel, where wT and wS are the wage
rates paid to workers in textiles and steel respectively. With homogeneous and perfectly mobile
labor, another condition must also hold, namely the labor constraint, LT + LS = L (3)
In other words, the labor used in textile production (LT) plus the labor used in steel
production (LS) must sum to the total labor endowment available in the economy (L). Finally,
also because labor is homogeneous and perfectly mobile between industries, wages must be
equalized in equilibrium between the two industries. Thus, wT = wS (4)
All four conditions above must be satisfied simultaneously in an equilibrium in this
model. To represent this equilibrium and to provide a medium to analyze potential changes, we
present a diagram developed by Mussa (1974). The uniqueness of the diagram is to present all
four conditions together on the same graph. The horizontal axis of the diagram plots the labor
supply. The vertical axis plots the wage and the
value of the marginal products.
The horizontal length of the diagram OTOs
represents the labor endowment (L), the total
amount of labor available for use in the economy.
The VMPT line slopes down from the left as
presented before. However, the VMPS line slopes
down from the right. This is done because the point
OS corresponds to zero units of labor used in steel
production and OTOs units of labor used in textiles.
As we move to the left from OS, labor used in steel increases while labor used in textiles
decreases. Thus, the VMPS line is flipped and drawn with respect to its origin at OS. Every point
along the horizontal axis corresponds to an allocation of labor between the two industries
satisfying the labor constraint condition (3). Thus at point like A, OTA units of labor are used in
textile production (LT) and OSA units of labor are used in steel production (LS). The sum of the
two equals OTOs which is the total labor endowment (L).
 At point E in the diagram, the two VMP lines intersect so that VMPT = VMPS,
determining the unique wage rate w = wT = wS using all of the available labor OTOs. Thus, at
point E all four equilibrium conditions listed above are satisfied.

The pattern of trade

The pattern of trade is the specific factors model; each country will export the good with
the absolute abundant stock of specific capital, assuming identical endowments of labor, the
mobile factors. With different in labor endowments, trade patterns will depend on the nature of
the production functions and on the allocation of capital.

Specific Factors Model to The Home Country

We’ll assume to use two countries: Home and Foreign. Manufacturing uses labor and
capital, and agriculture uses labor and land. In each industry, increases in the amount of labor
used are subject to diminishing returns, that is, the marginal product of labor declines as the
amount of labor used in the industry increases.

Opportunity Cost and Prices

As in the Ricardian model, the slope of the PPF equals the opportunity cost or relative
price of the good on the horizontal axis: here it is manufacturing. Firms hire labor up to the point
where the cost of one more hour of labor (the wage) equals the value of one more hour of labor
in production.

Specific Factors Model to the Foreign Country

To understand more about specific factor model, let us assume that the Home no-trade
relative price of manufacturing is lower than the Foreign relative price, (PM /PA) < (P*M /P*A).
This assumption means that Home can produce manufactured goods relatively cheaper than
Foreign, or, equivalently, that Home has a comparative advantage in manufacturing.
The good whose relative price goes up (manufacturing, for Home) is exported and the
good whose relative price goes down (agriculture, for Home) is imported. By exporting
manufactured goods at a higher price and importing food at a lower price, Home is better off
than it was in the absence of trade
Study Case: L’Oreal, Unilever
L’Oreal, the world’s largest cosmetic maker, expects to boost sales in Indonesia by as much as
35 percent in the next five years, Vismay Sharma, the company’s country head, said Oct. 29. The
Paris-based company is investing $128 million to build its largest factory globally in West Java
province.

Unilever plans to spend $150 million building a factory in Sei Mangkei, North Sumatra, that will
produce ingredients for soaps and shampoos, said Sancoyo Antarikso, a Jakarta-based director at
the unit of the second-largest consumer-goods maker.

Consumer-product companies like Unilever and noodle-maker Indofood CBP Sukses Makmur
will benefit from a government plan to raise minimum wages, according to John Rachmat, an
analyst at Mandiri Sekuritas, in a Nov. 22 report.

The Jakarta province will increase the minimum by 44 percent to Rp 2.2 million ($229) a month
in 2013 from this year, said Mandiri Sekuritas. East Kalimantan will boost the wage by 49
percent to Rp 1.75 million, while Papua, the eastern most provinces, will raise it by 8 percent to
Rp 1.71 million, according to the report.

Comment:

This is the example of specific factor model case, there are 2 countries; home and
foreign. The home country is Indonesia, the foreign country is France. They use three factors of
production; labor, capital and land.

From the case, we can get the idea if opening a country to international trade can leads to
overall gains, but in a model with several factors of production, some factors of production will
lose. The fact, some people are harmed because of trade, for example is the other domestic
company for cosmetic products in Indonesia that cannot compete with L’Oreal.

In the specific-factors model, factors of production that cannot move between industries
will gain or lose the most from opening a country to trade. So, in this case there are some
chances other factor of production for L’Oreal will face lose or win if the factor of production
cannot move between industries.
References
 Specific Factors Model ( International Trade Theory And Evidence By James R.
Markusen, James R. Melvin, William H. Kaempfer, Keith E. Maskus)
 Assumptions of the Model (International Economics Theory and Policy by Paul R.
Krugman and Maurice Obstfeld)
 Prices, Wages, and Labor Allocation (International Economics Theory and Policy by
Paul R. Krugman and Maurice Obstfeld)
 International Trade in the Specific Factors Model (International Economics Theory
and Policy by Paul R. Krugman and Maurice Obstfeld)
 Single Firm Equilibrium in the Specific Factor Model (International Trade Theory and
Policy by Steven M. Suranovic)
 Two Firm Equilibrium in the Specific Factor Model (International Trade Theory and
Policy by Steven M. Suranovic)
 The pattern of trade ( International Trade Theory And Evidence By James R.
Markusen, James R. Melvin, William H. Kaempfer, Keith E. Maskus)
 Specific Factors Model to The Home Country (International Trade by Robert C.
Feenstra and Alan M. Taylor)
 Specific Factors Model to The Foreign Country (International Trade by Robert C.
Feenstra and Alan M. Taylor)