Question

Home produces computers(C) and food(F) using capital(C) and labor(L). The unit factor requirements are fixed and given by: a_LC = 2, a_KC = 6, a_LF = 3, a_KF = 4. The total labor supply is 900 and the total capital stock is 1,500. Foreign, with a labor supply of 1,200 and a capital stock of 1,800. Foreign shares the same technology with Home ( a*_LC=2, a*_KC= 6, a∗_LF = 3, a∗_KF = 4). Home and Foreign engage in free trade. Suppose the world relative price of computers is given by PC/PF = 1.2.

a. Which country is relatively capital abundant and which labor abundant?

b. Describe the pattern of trade between Home and Foreign.

c. Show graphically the production and consumption of Home under free trade.

d. Who will gain and who will lose from free trade?

e. In which country are wages higher?

Answer 1

a) The ratio of capital to lalour (K/L) in Home= 1500/900 =5/3 = 1.67

The ratio of capital to labur (K/L) in foreign= 1800/ 1200 = 3/2 =1.5

As the capital labour ratio is higher in home, Home is a capital abundant courntry and Foreign is labour abundant country.

b) Computers are capital intensive goods, while food is a labour intensive comodity. As Home is capital abundant it must produce computer, while foreign being labour abundant must procude food (according to Hecksher- Ohlin theorem). Home would trade computers for food with foreig, while foreign would trade food for computers with home.

c)

RS is the relative supply curve of foreign while RS' is the relative supply of Home. The relative price of home was R3, while that in foreign was R1. When the countries started trading, the quantity of computers available to foreign increases, and the quantity of food available for home increases. This increases the relative price in home, while reduces the relative price in foreign and the would trade price lies in between the domestic and foreign relative price at R3.

d) Both the countries gain from trade, as the price of computers decreased in foreign while the price of food decreased in home.