Question

The US is a capital abundant country, and Mexico is a relatively labor abundant country. Assume that each country has an apparel industry (labor-intensive) and an automobile industry (capital-intensive). Assume that the two countries are originally in a state of autarky.

a) Use PPFs to show the outcomes in autarky.

b) Use the Heckscher-Ohlin-Samuelson (HOS) model to show what will happen when we

open up the two countries to free trade with one another.

c) What will happened to the production of apparel and automobiles in each country? Which

country will export which good?

d) What will happen to wages and rents, and to returns in both industries?

e) What happens to social well-being in both countries?

Answer 1

US = Capital Abundant Country

Mexico = Labour Abundant Country

Apparel industry = labour intensive, Automobile industry = capital intensive

a) Autarky is a state when both the countries are self-sufficient and not engaging in free trade. As US is capital abundant country = K/L > K*/L* for US, and L*/K* > L/K for Mexico

Take a look at fig 1 and 2 to see the PPF's of US and Mexico, the slope = P

Apparel i.e. labour intensive good is on the Y axis, Automobile i.e. capital intensive good is on the X-axis, Slope = Price of automobiles/Price of apparel,

As US is a capital abundant country, the price of the capital intensive good i.e. automobiles is lower in US than Mexico, similarly, as Mexico is labour abundant country, the price of the labour intensive good i.e. apparel is lower in Mexico than US,

So, the low relative price of automobiles in US, gives a flatter slope, in US 's PPF, high relative price of automobiles in Mexico, gives a steeper slope in Mexico's PPF.

Because US is capital abundant, the US 's PPF is skewed towards automobiles and vice versa for Mexico.

b) When we open up the two countries for trade, In Autarky,

Price of automobiles/Price of apparel in US < Price of automobiles/Price of apparel in Mexico,

US has a comparative advantage in Automobiles as it produces automobiles at a lower cost as compared to Mexico. Mexico has a comparative advantage in Apparel,

When there is free trade: The free trade relative prices of apparel and automobiles are such:

Price of automobiles/Price of apparel in US < World Price of automobiles/World Price of Apparel < Price of automobiles/Price of apparel in Mexico, take a look at fig 3 and 4 for the PPF's of US and Mexico after free trade.

c) Now, according to H-O theorem, a country that is capital abundant is well-endowed with this factor, this will give the country a propensity for producing that good which relatively uses more capital.Similarly is the case for labour abundant country, So, In US, the production of automobiles will increase, and in Mexico, the production of apparel will increase. Also, once free trade is allowed, profit-seeking firms of the country will shift their products to the markets which have a higher price, so thus the capital abundant country will export the capital intensive good i.e. US will export automobiles and import apparel, and Mexico will export Apparel and import automobiles.

d) The theorem says that as the price of the capital-intensive good increases, i.e. if price of automobiles increases, then the price of capital i.e. the factor which is used extensively in the good's production will rise, i.e. in US, the rent on capital will incraese while the wage paid to labour will fall. Similarly, in Mexico, the wage paid to labour wil increase and rent paid on capital will fall. A movement to free trade will result in the real return of the country's abundant factor to increase, while the real return of the scarce factor will reduce. i.e. the capital owners in the US will gain an increase in the real return i.e. the purchasing power of their rental income, while labourers real return will fall. Similarly, in Mexico, the labourers will get an increased real return on their wages while capital owners return will fall.

e) The H-O model says that both the countries will experience an increase in the aggregate efficiency. Each country will produce more of the good it has to export and less of the good it has to import. The production shifts will help to improve the productive efficiency in both US and Mexico. Also, due to the increase in prices, consumers of the countries will gain an improved consumption efficiency. So, the national welfare or social well-being will increase for both the countries due to free trade.