Question

Suppose that a Home country is a labor-abundant country, and produces bananas (labor intensive) and computers (capital intensive). Given all the theory and assumptions of the Heckscher-Ohlin model holds true, answer the following questions:

A). Draw and explain in a graph the free trade equilibrium for Home Country (Remember PPFs? Make sure to clearly indicate the production point, the consumption point, and the quantity of exports and imports).

B). In the graph drawn above for question (a), show the effects of a proportional increase in the endowments of labor and capital. Does welfare increase or decrease?

C). One of the justifications for import-substitution strategies is the deterioration of terms of trade. This means that the price of exports falls relative to the price of imports. In the graph for question (a), draw and show a graph how this would be represented. Does welfare increase or decrease?

D) Suppose that Home country is the main exporter of bananas in the world (meaning it is a large country, able to affect world prices), is it theoretically possible that economic growth decreases welfare for Home Country? Explain using a different graph from answers to questions (b) and (c). Be sure you type your answers and draw clean graphs.

Answer 1

A). In the following figure, Foreign produces at point P. The tangent line at P represents the national income line of foreign. Consumption in Foreign occurs where the aggregate indifference curve I_FT, representing preferences, is tangent to the national income line at C. To reach the consumption point, foreign exports EXc and imports IM_B.

Home produces at point P*. The tangent line at P* represents the national income line for the home economy. The slope of the income line is also the free trade price ratio (P_B/P_C)_FT. Consumption in home occurs where the aggregate indifference curve I_FT*, representing preferences is tangent to the national income line at C*. Foe home to reach its consumption point, it exports EX_B* and imports IM_C*.

B). In the following figure, suppose, the indifference curve intersects the countrys' PPF at point A. Next, suppose that labour and capital are shifted between the two countries. Suppose labour is moved from Foreign to home, while capital is moved from home to foreign. Thus now home is labour abundant and foreign is capital abundant. thus their PPF will shift. The PPF of foreign shifts from PPF0 to PPF. The PPF of home shifts from PPF0 to PPF'. This will lead to increase in production of computers(capital intensive good) in foreign and increase in banana(labour intensive good) production in home.

Yes, the level of welfare increases because home as well as foreign increases the production of that commodity in which it is abundant and has specialisation of production.