International Trade Theory and Policy
by Steven M. Suranovic

Trade 60-12

The Distributive Effects of Free Trade in the H-O Model

"Distributive effects" refers to the distribution of income gains and/or losses across individuals in the economy. In the H-O model there are only two distinct groups of individuals: those who earn their income from labor (workers) and those who earn their income from capital (capitalists). In actuality many individuals may earn income from both sources. For example, a worker who has deposits in a pension plan which invests in mutual funds has current wage income, but changes in rental rates will affect his or her future capital income. This person's income stream thus depends on both the return to labor and the return to capital.

For the moment we shall consider the distributive effects on workers who depend solely on labor income and capitalists who depend solely on capital income. Later we shall consider what happens if individuals receive income from both sources.

To measure gains or losses to workers and capitalists we must evaluate the effects of free trade on their real incomes. Increases in nominal income are not sufficient to know whether an individual is better off since the price of exportable goods will also rise when moving to free trade. By assessing the change in real income, we can determine how the purchasing power of workers and capitalists is affected when moving to free trade.

Suppose there are two countries, the US and France, producing two goods, clothing and steel, using two factors, capital and labor, according to an H-O model. Suppose steel production is capital-intensive and the US is capital-abundant. This implies that clothing production is labor-intensive and France is labor-abundant.

If these two countries move from autarky to free trade then, according to the H-O theorem, the US will export steel to France and France will export clothing to the US. Also, the price of each country's export good will rise relative to each country's import good. Thus in the US (PS/PC) rises, while in France (PC/PS) rises.

Next we apply the magnification effect for prices to each of the country's price changes.

In the US, , that is, if the ratio of prices rises it must mean that the percentage change in PS is greater than the percentage change in PC. Then applying the magnification effect for prices implies,

This in turn implies that,

which means that the real rent in terms of both steel and clothing rises.

And

which means that the real wage in terms of both steel and clothing falls.

Thus, individuals in the US who receive income solely from capital are able to purchase more of each good in free trade relative to autarky. Capitalists are made absolutely better off from free trade.

Individuals who receive wage income only, are able to purchase less of each good in free trade relative to autarky. Workers are made absolutely worse off from free trade.

In France, , that is, the percentage change in PC is greater than the percentage change in PS. Then according to the magnification effect for prices,

This in turn implies that,

which means that the real wage in terms of both clothing and steel rises.

And

which means that the real rent in terms of both clothing and steel falls.

Thus, individuals in France who receive wage income only, are able to purchase more of each good in free trade relative to autarky. Workers are made absolutely better off from free trade.

Individuals in France who receive income solely from capital are able to purchase less of each good in free trade relative to autarky. Capitalists are made absolutely worse off from free trade.

These results imply that both countries will experience a redistribution of income when moving from autarky to free trade. Some individuals will gain from trade while others will lose. Distinguishing the winners and losers more generally can be done by referring to the fundamental basis for trade in the model. Trade occurs because of differences in endowments between countries. The US is assumed to be capital-abundant and when free trade occurs, capitalists in the US benefit. France is assumed to be labor-abundant and when free trade occurs, workers in France benefit.

Thus, in the H-O model, a country's relatively abundant factor gains from trade while a country's relatively scarce factor loses from trade.

It is worth noting that the redistribution of income is between factors of production and not between industries. The H-O model assumes that workers and capital are homogenous and are costlessly mobile between industries. This implies that all workers in the economy receive the same wage and all capital receives the same rent. Thus if workers benefit from trade in the H-O model it means that all workers in both industries benefit. In contrast to the immobile factor model, one need not be affiliated with the export industry in order to benefit from trade. Similarly, if capital loses from trade then capitalists suffer losses in both industries. One need not be affiliated with the import industry to suffer losses.

International Trade Theory and Policy - Chapter 60-12: Last Updated on 7/31/06

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