Question

Suppose that there are drastic technological improvements in shoe production in Home such that shoe factories can operate almost completely with computer-aided machines. Consider the following data for the Home country:

Shoes:  Sales revenue = Ps x Qs = 100 , Payments to labor = W x Ls = 10 , Payments to labor = R x Ks = 90 , Percentage increase in the price = ∆Ps/Ps = 40%

Computers: Sales revenue = Pc x Qc = 100,  Payments to labor = W x Lc = 50 , Payments to capital = R x Kc = 50,  Percentage increase in the price = ∆Pc/Pc= 0%

a. Which industry is capital-intensive?

b. Given the percentage changes in output prices in the data provided, calculate the percentage change in the rental on capital.

c. How does the magnitude of this change compare with that of change in the earnings of labor?

d. Which factor gains in real terms, and which factor loses? Are these results consistent with the Stohlper-Samuelson theorem?

Using a diagram of relative labor demand (RD), show the effect of a decrease in the relative price of computers in Foreign. What happens to the wage relative to the rental? Is there an increase in the labor-capital ratio in each industry? Explain.

Answer 1

Solution for the above problem

c)

It is clear from the calculation shown above in part (b), the percentage change for the rental of capital in the shoe industry, the magnitude of the changes are equal but with opposite sign

(d)

There are capital gains in real terms because the increase in capital returns exceeds the change in price for both industry, while there is labor loses in real terms because of decrease in wage and the output prices remains the same or increased for both industries.

This is consistent with the Stolper-Samuelson theorem. As we know that in the long run, when all factors are mobile, an increase in the relative price of a good will cause the real earnings of labor and capital to move in opposite directions, with a rise in the real earnings of the factor used intensively in the industry whose relative price went up and a decrease in the real earnings of the other factor.

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