Question

1. Consider a 2x3 specific-factors model, with all associated assumptions, where Home is a small country and has two sectors, (i) light manufactured goods and (ii) industrial goods, and three factors, (i) capital (which is mobile between sectors), (ii) unskilled labor (which is specific to light manufacturers) and (iii) skilled labor (which is specific to industrial goods).

a) Suppose, after opening to trade, Home experiences a significant inflow of foreign direct investment (FDI). What do you expect to happen to the production of light manufacturers and the production of industrial goods? Explain.

b) Suppose, after opening to trade, Home experiences a significant inflow of foreign direct investment (FDI). What do you expect to happen to the real return to capital? Explain.

c)Suppose, after opening to trade, Home experiences a significant inflo of foreign direct investment (FDI). What do you expect to happen to the real return to skilled labor? Explain.

d) Suppose you are deciding between relying on capital as your primary source of income OR relying on your labor as your primary source of income. Moreover, imagine you had to make this decision before learning Homes comparitive advantage. To what extent would you face a risk-reqard tradeoff in the context of this model? Explain

Answer 1

a. Inflow of foreign direct investment will increase the manufacturing of industrial goods as compared to light manufacturing goods. This is because foreign investment mainly takes place in industrial goods. Thus, production of industrial goods will increase and production of light manufacturing goods will decline.

b. Increase in the foreign direct investment will increase the level of investment in the economy. Thus, investment curve shifts out in loanable fund market and thus real return on capital or real interest rate will increase in the economy.

c. The return of the skilled labor will also increase as foreign capital will demand more number of skilled labor to do the work as compared to unskilled labor.

d. It depend on the nature of the labor whether the labor is skilled or unskilled. Also , the comparative advantage of the nation also plays an important role. If demand for capital is more then return on capital will be more and if demand for labor is more then return on labor will be more. Thus, comparative advantage play an important role in this case.