Question

Suppose there exist 2 countries, Home and Foreign; 2 goods, X and Y; and 2 factors of production, labor (L) and capital (K). Each country can produce both goods. X is labor-intensive and Y is capital-intensive. Home is labor-abundant and Foreign is capital-abundant. Assume that the standard assumptions of the Heckscher-Ohlin model hold. When answering the following question, please support each of your arguments with detailed analysis and draw the relevant diagrams to support your answer.

Consider a move from autarky to free trade between the two countries in both goods. Identify which group of people (laborers or owners of capital) gain and which lose in Home from the move from autarky to free trade. Discuss clearly how the assumptions of the model lead to this result.

Answer 1

We know that as (as/ac)X <(as/ac)W, which implies that both the autarky opportunity cost and relative price of a product"A" in terms of other product "B" is lower in country X. Therefore, with trade, the relative world price for product"A" is higher for consumers in X than it was in autarky. Even still, since world prices dier from autarky prices, there are gains from trade, which implies that consumption in X increases. Since consumption = income = wages, wages unambiguously increase.

On the basis of this assumption the labourers will be benefited due to the increase in wages relative to the increase in consumption.

In world trade equilibrium, wages are the same in home and foreign, w = w∗. What good(s) will Home produce? What good(s) will Foreign produce? Each country’s production is determined by comparing the unit production costs, or ai × w vs. a∗ i × w∗, for each good i. Whichever country has the lower unit production costs will produce the good. Since w = w∗, comparative advantage is determined by directly comparing the ULR’s of each country. Therefore, Home will produce prodct "A" and product "B" and Foreign will produce product"C'.