Question

Consider two countries​ (Home and​ Foreign) that produce goods 1​ (with labor and​ capital) and 2​ (with labor and​ land). Initially, both countries have the same supply of labor

​(100 units​ each), capital, and land. The capital stock in Home then shrinks.

This change shifts in both the production curve for good 1 as a function of labor employed and the associated marginal product of labor curve. Nothing happens to the production and marginal product curves for good 2.

a. Show how the decreased in the supply of capital for Home affects its production possibility frontier.

Using the​ three-point curved line drawing​ tool, draw a new PPF for Home that reflects the decreased in the supply of capital. Properly label the curve.

Carefully follow the instructions above and only draw the required object.  

Answer 1

As per the given conditions, Both Home and Foreign countries two goods, Good 1 which is a function of factors Labor and Capital and Good 2 which is a function of factors Labor and Land. The units of labor they both possess is 100 units. If the capital in the home country shrinks, then the flow of the required capital in the economy will drastically come down. This lack in the flow of capital will reduce the availability of funds in the hands of the home country. The Home country will then not be able to push in the required investment necessary to maintain the same level of production of Good 1. This will therefore directly result in the reduction of the quantity of the production of Good 1 in the home country. Moreover, due to the reduction of the production unit, the revenue generated from Good 1 will also reduce and in the longer run, this will force the home country to reduce the wage level of its labor or curtail the employment of its labor. Therefore, the reduction of capital flow in the Home country will result in the reduction of both production output and in the longer run it will also affect the employment of labor in the economy.

                                                  If we see the diagram above, we see that the Capital flow in the Home country for Good 1 is represented in the X axes and the Labor supply in the Home country for Good 1 is represented in the Y axes. OQ is the supply of labor (which is 100 units), and OB is the capital flow in the economy. This results in the Production Possibility Frontier of PPF1 in the economy with a total production of OQCB. However, when the supply of capital shrinks in the Home country, the availability of capital falls down in the market from OB to OA. The units labor remains the same in the shorter run. As a result of this reduction in the capital flow, the Production Possibility Frontier PPF2 now forms and cuts the labor function at the point D, thereby creating AD as the supply of labor and OA being the supply of capital. As can be seen from the diagram above, OQDA is the new production of Good 1 in the market which has now shrieked too.