Question

1. Assume that the assumptions of the Heckscher-Ohlin model are holding. There are two inputs, labor and capital. There are two goods, automobiles and clothing. Automobiles are capital-intensive, and clothing is laborintensive. Assume that Canada is the relatively capital abundant country. Answer the following questions about the effect of trade on Canada:

a. As it begins to trade, which good will Canada export, and which good will Canada import?

b. What will happen to the price of automobiles and the price of clothing in Canada as it moves from autarky to trade?

c. In Canada, what will happen to the demand for capital, and to the demand for labor as the country begins to trade?

d. What will happen to the price of capital in Canada as it moves from autarky to trade?

e. What will happen to the capital-labor ratio in the Canadian automobile industry as Canada begins to trade? What will happen to the capital-labor ratio in the Canadian clothing industry as Canada begins to trade? Show this in isoquant-isocost diagrams.

f. What will happen to the marginal product of capital in Canada as Canada begins to trade? What will happen to the marginal product of labor in Canada as Canada begins to trade? Why?

g. What will happen to the real income of the owners of capital in Canada, as Canada begins to trade? Explain why

Answer 1

According to Hecksher-Ohlin theorem countries which are rich in labour, export labour intensive goods and the countries which are rich in capital will export capital intensive goods.

a)since Canada is capital abundant country it will export capital intensive goods i.e automobiles and import labour intensive goods I.e clothing

b) In autarky , the price of automobiles would start to bid down due abundant production of automobiles, but as Canada begins to trade producers now move their product to those countries where the price of their good is temporarily high.

Thus , price of automobiles back home, in Canada starts to rise.

Price of clothing was high in autarky as labour being expensive. Now with trade , price of clothing starts to fall down due to import of clothes from labour abundant countries that would give them clothes at temporarily cheap price

c) as Canada begins to trade , it thus can import labour abundant goods I.e. clothes hence demand for labour falls and as it begins to export automobiles, the demand for capital increases.

d)as the countries begin to trade , the price of factors will also be equalised among them.

So, price of capital will now rise in canada

e) in Canadian automobiles industry capita-labour ratio will rise due to increase in the demand for automobiles.

In clothing industry due to imports of clothes , the demand for labour decreases and hence capital labour ratio will rise in Canadian clothing industry.

f) with every unit increase in the capital , its productivity decreases following the law of diminishing returns and hence the marginal product of capital decreases when Canada begins to trade.

The marginal product of labor increases as its demand decreases

g) real income of the owners of capital in Canada will increase with opening of trade as it gets a larger market to sell automobiles. Due to opening of trade the resultant prices rise leaving them better off.hence their real income rises