Question

Suppose there are two goods, cameras and DVRs, produced in a country. Cameras (Qc) are

labor-intensive and DVRs (Qd) are capital-intensive in their production. The wage paid to

labor is w and the rent on capital is r. We assume the country to be capital-abundant and the

relative price of cameras to price of DVRs is Pc . The country undertakes an agreement withPd

its trading partner which lowers the price of imports, leading to higher levels imports.

(a) Write the equation for the iso-value line.

(b) Draw the PPF and the tangent iso-value line. Note: Cameras is on the y-axis and DVRs is on the x-axis.

(c) Which of the two goods, cameras or DVRs, is expected to experience an in- crease in its relative price in the domestic market as a result of free trade?

(d) How will the change in the wage rate to capital rental ratio impact the labor to capital ratio in production of both goods?

(e) Who are likely to be the winners from free trade: labor or capital owners?

Answer 1

Answer to part a :-

The value of production lies of PPF when the economy maximises it's production possibilities.

Let the cameras be C and the DVR's be D then the ISO Value equation will be :

V= PcQc + Pd Qd

where the slope of the equation's line will be equal to Pc /Pd

Note - if the relative price changes the slope also changes , it gets steeper .

Because DVR's are more capital intensive and the economy is capital intensive thus we can conclude a equation as :

aLF /aKF >aLC /aKC

Answer to part b :-

In the above figure

The slope of the ISO value line is Pc /Pd .

The production is at point where PPF is tangent to ISO value line

Answer to part c :-

Due to free trade the import restrictions are demolished and the country will produce more of DVR as it capital intensive economy and now it will important cheap labour for optimum production efficiency.

As a result

Production curve will shift .

Supply of DVR relative to Cameras Qc/Qd rises.

Relative price of DVR to camera also increases in the same ratio as relative supply .

Answer to part d :-

r = rent given to entrepreneur for investment of his capital.  

w= wages given to labour

Change is relative ratio of rent to wages = Change in relative ratio of capital to labour .

Thus both the ratio will show a tendency to change in same proportion.

Answer to part e :

In the given case capitalist will enjoy benefit as they will import cheap labour from other countries and with the optimum usage of the capital factor (assuming other factors constant ) they will tend to maximize their profits .