Question

This question will ask you to use the Specific factor model to analyse how a change in the relative price of textiles and IT services affects income inequality. Assume that there are two consumption goods: textiles and IT services. There are three production factors in this economy: unskilled workers, skilled workers and capital. Assume that unskilled workers can only work in the textile sector and skilled workers can only work in the IT services sector, while capital can work in both sectors. Assume furthermore that the country we analyse is small.

a) Derive and draw the Product Possibility Frontier (PPF) for textiles and IT services in the economy. Explain your answer.

b) How is the optimal allocation of capital between the two sectors determined under autarky? Explain your answer.

c) Assume now that the country opens up to trade. We assume that the global relative price of textiles in terms of IT services is lower than the autarky relative price in the country we analyse. How does this affect the allocation of capital in the country? Explain your answer.

d) What will the pattern of trade be for the country? Explain your answer.

e) Derive and describe the effect of trade on the real wage of unskilled and skilled workers. What is the effect of trade on income inequality? Explain your answer.

f) If you compare the Specific factor model with the Heckscher Ohlin model, which model would you say is best at explaining short term effects and which is best at explaining long term effects? Explain your answer.

Answer 1

a)

As capital is limited in the country, so, either it will be used to produce textile or IT services or a combination of the two.

Above PPF Graph shows the opportunity cost related to both, and the different combination of both

b)

The point where indifference curve touches PPF, is the point where utility is maximised.

So, the optimal allocation of capital will be when utility is maximised.

This point shows some combination of IT services and Textile. This combination should be maintained for the capital.

c)

Global relative price of textile is lower. So, this country will import some part of the textile. Domestic production of textile will reduce. Capital consumed in textile production will reduce.

Capital consumed into IT services will increase and IT services domestic production will increase.

d)

This country will import textile as the global prices are lower. Also, they may export IT services as they have higher domestic production(higher capital employed) for IT services.

e)

This trading pattern will reduce employement in textile sector and will increase employment in IT sector.

Unskilled workers will not be happy as their jobs will reduce.

So, wages of skilled workers will increase, wages of unskilled workers will not grow.

This will increase income inequality.

f)

Hecksher - Ohlin model takes both labor and capital as variable.

Specific factor model takes only labor as variable.

In short run only labor is variable while capital is considered to be constant.

So, specific factor model best explains short term changes. Although the same can also be explained by Hecksher-Ohlin model.