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Factor market distortions and the gains from trade Lemche, Soren Qvistgaard

Abstract

The aim of the present study is to provide a rigorous static and comparative statics analysis of a two-factor, two-commodity model of an open economy, which is characterized by a distortion in the factor market. The presence of the distortion causes an inefficient allocation of factors of production and a divergence between the private and social rates of transformation. By employing a construction of the production possibility curve in a box diagram it can be shown that as the distortion increases, this curve will turn convex to the origin. Thus, the usual trade geometry will not suffice in determining either the direction of substitution in production or the direction of change in social utility, which results from an opening of the economy to trade. A geometrical analysis is not rigorous enough and only an algebraic model with specified production and utility functions will be adequate in analyzing the directions of variations in endogenous economic variables for given changes in exogenous variables. Such a model has therefore been employed and it has been solved for changes in both the distortion parameter and the commodity price ratio. The results of the model show that the variation in the private rate of transformation is more important than that in the social rate of transformation. Hence, the actual curvature of the production possibility curve in this case does not indicate the direction of substitution in production resulting from a given change in the commodity price ratio. It will be proven that the definition of factor intensities in production is of importance. The distortion in the factor market makes it possible to satisfy a given factor intensity condition defined in terms of input ratios while the corresponding condition defined in terms of elasticities in the production functions is either satisfied or violated. From the analysis it emerges that the existence of a distortion will lead to modifications of the familiar propositions concerning free trade. Thus, it is found that the effects on social utility from an opening of trade will depend on the correspondence vis-a-vis non-correspondence between the two definitions of factor intensities. In the analysis of the effects of a change in the distortion parameter, it is found that under certain conditions an exogenous increase in this parameter will lead to increased social utility. Although this study comments on and suggests some revisions of existing theory, it is considered to be an exercise in the pure theory of international trade and is entirely theoretical in that an empirical justification for the assumptions employed will not be attempted.

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