Question

1. [13 marks]

Assume that country D is a capital-abundance large-country and produces two goods, Steels and Foods. Production of steels is capital-intensive while production of foods is labor-intensive.   Suppose there is an increase in the endowment of capital in country D, while labor force is fixed.

Using the Rybczynski theorem, explain the production effects due to the increment in capital stocks in country D (the production of steels and the production of foods after economic growth).   

Explains the implications production changes on the international trade (trade effect of productions).       

Assume change in consumption is pro-trade effects. Predicts the total trade effects (the combinations of production- and consumption-effects).

Explains how the total trade effects influence the term of trade for country D.

Explains the income effects due to the increment in capital stock.

What is the net welfare effects of growth in capital stocks for country D?

Illustrate your answer in (Using the Rybczynski theorem, explain the production effects due to the increment in capital stocks in country D (the production of steels and the production of foods after economic growth).) until (What is the net welfare effects of growth in capital stocks for country D?) in an appropriate diagram.

Answer 1

Q1) The Rybczynski Theorem (RT) states that if the endowment of a certain resources increases, the industry which utilizes that resource most intensively, will experience an increase in the output, while the other industry will experience a decrease in output.

So, here, country D is capital intensive, producing two goods, capital intensive steel and labour intensive food. If there is an increase in the endowment of capital in country D, this will cause an outward shift of the capital constraint, the PPF , and thus, the production of the capital intensive good, i.e. steel increases. The production of the labour intensive i.e. food decreases. Now, the trade effect of production will be that price of steel is relatively lower and price of food is relatively higher. So, country D will export steel and import food. So, a lower price of the exportable commodity steel and a higher price of the importable commodity food , implies there is a deterioration of the terms of trade after the increase in supply of capital .

Pro-trade production effect implies that the production of the export good, i.e. steel grows faster as compared to the imported good i.e. food at constant relative good prices. Growth results in greater than proportionate expansion of trade.

Pro-trade consumption effect implies that consumption of import good i.e. food grows faster as compared to the consumption of export good i.e. steel at constant prices and leads to a greater than proportionate expansion of trade.

As production and consumption, both are pro-trade effects, the volume of trade expands or grows proportionally faster than output. This is the total trade effects.

The total trade effects is a combination of the production and consumption effects, Now, as consumption if imports is more than consumption of exports, the country is receiving less for its exports as compared to imports, so, there is an increase in demand for imported goods which increases the price of imported goods and decreases the price of exported goods. This causes the Terms of Trade (TOT) to deteriorate or decrease.

Now, because of the increment in the capital stock, the resource capital is abundant compared to labour, Income for capital owners reduce as there is abundant capital, the income for labour owners increase. Also, the change in the output per worker is increased as each labour has more capital to work with, as K grows proportionately more than L, K/L will increase, there is a higher productivity of labour, the real per capita income will increase. So, there is a higher/positive wealth effect, which tends to increase the country's welfare. Now, as the wealth effect and the TOT move in opposite directions, the nations welfare may or may not increase. depending on the relative magnitude. So, if wealth effect is greater than TOT effect, the welfare increases , so, growth increases net welfate, but not as much as in the case of a small country.

Take a look at fig 1.