Question

A free trade equilibrium exists in which the United States exports machinery and imports clothing from the rest of the world. The goods are produced with two factors: capital and labor. An increase now occurs in the U.S. endowment of capital, its abundant factor.

A. What is the effect on the shape and position of the U.S. production possibility curve?

B. What is the effect on the actual production quantities in the United States if the commodity price ratio is unchanged? Explain.

C. What is the effect on the U.S. willingness to trade?

D. Assuming that, the U.S. growth does affect the international equilibrium price ratio, what is the change in this price ratio?

Answer 1

1):-The entire US production possiblity curve shifts out, with the outward shift larger for the good that is intensive in capital. If the US trade pattern follows the HO theory, then this good is machinery. Growth is biased towards machinery products.

2) :-According to Rybczynski theorem, the quantity produced of machinery increases and the quantity produced of clothing decreases if the product price ration is unchanged. The extra capital is used to produce more machinery and the industry must also employ more labor to use with the extra capital. The extra labor is drawn from the clothing industry so clothing production declines.

3) :-The US willingness to trade increases. With growth of production and income, the US wants to consume more of both goods. Demand for of imports of clothing increases because domestic consumption increases while domestic production decreases.

4) :-The increase in demand for imports tends to increase the international equilibrium relative price of clothing. The increase in supply of exports tends to lower the international equilibrium relative price of machinery.