Question

Two large countries, the US and China, produce only two goods, manufactured goods and financial services, using two factors of production, skilled and unskilled labour. The production of financial services is relatively skill-labour intensive and manufacturing is unskilled-labour intensive. The US is relatively well endowed with skilled labour, whereas China is relatively
well endowed with unskilled labour. Assume that each society‘s preferences over the two goods are identical.
(a) Draw the production possibilities frontier (PPF) for the US. Carefully explain the shape of the PPF. How will the PPF of China differ?
(b) Suppose there is no trade between the two countries. Explain why, in a competitive equilibrium, the relative price of financial services must be lower in the US than in China.
(c) Explain why the neoclassical (HecksherOhlin) theory of trade implies there must be an increase in the goods available for consumption in both countries as a result of opening to free trade. Does this imply that all households in each economy will gain from trade? Explain.
(d) Provide a coherent economic argument to justify a protectionist policy in China that imposes a tariff on financial services from the US. What problems may arise in following such a strategy in the long run?

Answer 1

So, in this problem there are two country “US” and “China” and two goods “M=Manufacturing” and “F=Financial Services”. Consider the following fig of “PPF” of two country. We have measured “M” on the horizontal axis and “F” on the vertical axis.

Now, we can see that “China’s” PPF is “Manufacturing biased, because “China” is “unskilled labor” abundant country and “M” is “unskilled labor” intensive, => “China” will be able to produce more “Manufacturing” goods by devoting all the available resources compare to “Financial Services”, => it’s PPF should be “M” biased.

Now, “USA’s” PPF is “Financial Service” biased, because “USA” is “skilled labor” abundant country and “F” is “skilled labor” intensive, => “USA” will be able to produce more “Financial Services” goods by devoting all the available resources compare to “Manufacturing”, => it’s PPF should be “F” biased.

b).

Now, if there will not be any trade between two country, => both country will produce exactly what they consumer, => the production point must be the consumption point as well on the PPF in autarkic situation.

So, we know that “China” is “unskilled labor” abundant, “M” is “unskilled labor” intensive and both country have same preference, => the production of “M” should be more than “F” in China. Similarly, “USA” is “skilled labor” abundant, “F” is “skilled labor” intensive and both country have same preference, => the production of “F” should be more than “M” in USA. So, we can say that the relative price of “M” should be less in China compared to “USA”, => the relative price of “F” should be less in “China” compared to “USA”.

c).

In autarkic situation both country will consume exactly what they produce, => “China” is “unskilled labor” abundant, “M” is “unskilled labor” intensive good, => “China” can able to produce additional “M” by reducing less than 1 units of “F”. Now, if the post trade relative price of “M” will be more than autarkic, => there is a possibility to produce more of “M” and less “F”, and export some “M” in exchange of “F”. So, that the post trade consumption is more than the autarkic. Similarly, we can explain that for “USA” also to increase the post consumption of both goods.

AS we know that the autarkic relative price of “M” must be less compared to “USA” and autarkic relative price of “F” must be less in “USA” compared to “China”, => there is full possibility that if both country trade to each other, => there relative price of each goods will converge to each other and both of them will be able to increase their post trade consumption.

d).

AS we know that both the country are larger, => both have significant power to influence the world market by taking different trade policies. So, if “China” impose tariff on “F” coming from “USA”, => the relative price of “F” in “China” will increase and the world relative price of “F” will fall, as it will create excess supply of “F” in the world market, => the “welfare” of “China” will increase and the same of “USA” will decrease.

But in the LR problem may arise, because as “China” impose tariff on “F”, => “USA’s” welfare decreases, => “USA” may decide to impose tariff on “M” coming from “China”. So, because of the imposing of the tariff both the countries welfare decreases compared to “free trade”.