Question

In a Heckscher-Ohlin model, suppose there are two countries: Scotland and Portugal. Two goods are produced in this world: cheese ( C) and wine (W). Cheese and wine are both produced using two factors of production: labour (L) and land (T). Wine is land-intensive while cheese is labour-intensive. Suppose that Scotland and Portugal have the exact same quantity of labour, but Scotland has more land than Portugal. Assume that the post-trade world relative price of cheese is the mean (average) of the two countries’ pre-trade relative prices, so that world relative prices converge exactly towards the middle of the two countries’ prices.

a) Draw Scotland and Portugal’s RS curves on a RS-RD diagram, clearly labelling each curve, each country’s pre-trade relative prices and quantities of cheese, as well as the world post-trade relative price and quantities of cheese. Briefly describe, in one or two sentences, why the RS curves of each country are located where you have drawn them.

b) Scotland suddenly receives an increase in labour. Assume that Scotland does not trade before or after the increase in labour, and that output prices do not change either. Describe what happens to Scotland’s production of each good, its factor prices, and input mix in each sector. Draw Scotland’s PPF before and after the increase in labour, with cheese on the horizontal axis and wine on the vertical axis.

c) Take the same increase in labour for Scotland from the previous part. Assume now that Scotland DOES participate in international trade both before and after the increase in labour, and that output prices can change as well. What happens, before and after the labour increase (assuming Scotland traded with Portugal both before and after), to: 1) Scotland’s RS curve (draw the RS-RD diagram with Scotland’s new and old RS curves, Portugal’s RS curve, and the RD curve), 2) Scotland’s production (using a PPF diagram), exports, and imports, and 3) Scotland’s output prices, factor prices, and input mixes. Hint: you may find that there is ambiguity about what happens because you do not know exactly how much labour is added, and that there are a few different scenarios that could occur, depending on how much labour is added. For full marks, you should describe what happens in each of those cases.

Answer 1

Here “Scotland” and “Portugal” have exactly same quantity of “L” but “Scotland” has more “T” than “Portugal”, => “Scotland” is relatively land abundant country compare to “Portugal”, because “Scotland” have more “T/L” compare to “Portugal. So, here we can say that “Portugal” is relatively “labor” abundant country. Now, “W” be the land intensive good and “C” be the labor intensive good, => the “relative supply of Cheese to Wine” is more for “Portugal” compared to “Scotland”. So, the relative supply of “C” of “Portugal” will be more compare to “Scotland”. Consider the following fig.

  

So, here “RSs” be the relative supply of “C” to “W” of “Scotland” and “RSp” be the relative supply of “C” to “W” of “Portugal” and they both have same “RD”, => “ps” be the autarkic relative price of “C” of “Scotland” and “pp” be the autarkic relative price of “C” of “Portugal”. Finally “p*” be the free trade equilibrium relative price of “C”.

b).

Consider the following fig shows the PPF of “Scotland”.

So, as we know that “Scotland” is “land” abundant country, => the PPF is biased toward “W” which is a “T” intensive good and “A1A2” be the initial PPF. So, as “L” increases the PPF will shift biasly toward “C” since “C” is “L” intensive good, => the new PPF is given by “B1B2”. So, as the PPF shift, => the “RSs” will shift towards the right side given the RD, => the autarkic relative price of “C” will decreases in “Scotland”.

c).

Consider the following fig showing the “RS” of Scotland, => as the labor increases, => the “RS” will shift to “RSs2” but the “RS” of Portugal will not change.

Now, under free trade the equilibrium relative price of “C” will be determined by the intersection of “world relative demand for C” and the “world relative supply of C”. So, as the “RS” of Scotland will increases, => the world relative price of “C” also decreases.

Consider the following fig.

So, here “P1” be the initial production point the tangency condition between the initial PPF and initial relative price and “C1” be the initial consumption point the tangency condition between initial relative price and initial utility function. Now as the PPF shift, => “P2” be the initial production point the tangency condition between the new PPF and new relative price and “C2” be the new consumption point the tangency condition between new relative price and new utility function.

So, here we can see that as the relative price decreases, => the import of “C” in Scotland increases and export decreases.

As, we know that under free trade the equilibrium relative price of “C” will be determined by the intersection of “world relative demand for C” and the “world relative supply of C”. So, as the “RS” of Scotland will increases, => the world relative price of “C” also decreases and there is positive relation between the output price ratio and the input price ratio, => as the relative price decreases, => the “w/r” ratio also decreases.