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Re-Allocating Production Factors and International Trade

Free trade and the laws of comparative advantage are one of the most famous outputs of economic theory. Free trade allows an economy to specialize in the production of the good in which it has a comparative advantage and then trade some of their goods for others produced elsewhere, achieving an expanded consumption possibility set. The recognized advantages of free trade have led to the creation of several free trade agreements and organizations (such as the WTO – World Trade Organization) between various economies.

However, despite its benefits, open trade can bring several challenges to an economy. Under the general equilibrium model, Stolper and Samuelson (1941) describe that a change in the relative prices of a good, will lead to an increase in the return in the production factor that is most intensively used to produce the good. Applying this to international trade, once an economy opens itself to world prices; it is natural that the relative prices of most goods will change. This will improve the conditions of those endowed with most intensively used production factors of the “expensive” goods, while penalizing those with less intensive production factors; for example human capital versus unskilled labour.

As a result, many developed countries have seen inequality rise, with wages increasing at different paces in different sectors. In many developed economies, there has been a clear increase in the divide among those employed in services sectors and those employed in industrial and agricultural sectors. The figure below illustrates this well in the form of the economic activity of each sector in developed countries, where the services sector has greatly increased.

To relate this to the Stolper-Samuelson effect and focusing on services and agricultural sectors, we can simplify the production factors to human capital, intensively used to produce goods coming from the services sector and unskilled labour, intensively used to produce agricultural goods. What we have seen happen in many economies is that the price ratio of service goods to agricultural goods has increased over the past decade (possible reasons include higher global competition in agricultural goods while many services are non-tradable). From the change in relative prices we have that those endowed with human capital have benefited from this change as human capital is intensively used to produce the “expensive” good.

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Ricardo Barahona, 83

References:

Stolper, W. F. & Samuelson, P. A. (1941), “Protection and Real Wages”, Review of Economic Studies 9 (1): 58–73

Trade and Stuctural Adjusment, OECD, 2005 – http://www.oecd.org/general/34753254.pdf

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Author: studentnovasbe

Master student in Nova Sbe

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