Question

International Economics Question!!

Home and Foreign are two countries that produce cloth and food, and trade these goods with each other. Both goods require labor as an input. Capital is an input for cloth production, and land is an input for food production. In other words, capital and land are specific factors for cloth and food production respectively. There are diminishing returns to labor.

Suppose that the capital stock of Home increases due to an external shock.

a) How would the production function of the cloth sector and marginal productivity of the cloth sector change?

b) PPF of Home change? Plot Home’s initial PPF diagram and show the impact of this effect on the figure.

c) Before any change in the relative price, how do you expect output of food and cloth to be impacted? Demonstrate on the new PPF curve.

d) As a result of the increase in capital, how would the relative price of cloth be impacted? (Use the goods market equilibrium to demonstrate this effect).

e) As a result of this price change, how would the output of food and cloth be impacted? Demonstrate on the PPF curve.

f) How would the labor market allocations and wage be impacted as a result of the increase in capital? (Plot a labor market equilibrium in the Home country and demonstrate this effect).

Answer 1

Given that home country and foreign country produce and trade in cloth and food. Cloth industry is capital intensive and food industry is land intensive. Factor intensity means an output requires more of a factor with respect to another factor for its production.

(a)

when capital stock increase because of external shock, cloth sector which requires capital more intensively will increase its production and hence its production possibility curve would shift outwards. but marginal productivity would not change as it is an autonomous change so price relative slope will remain constant but now more cloth will be produced than food.

(b) home country will produce more cloth than food now and this can be seen in the figure below

(c)

According to hecksher Ohlin model, a country will specialise in the production of the good for which it has factor intensity and would produce less of that good which uses its scares factors.

In the given model, Home country produce more of cloth as its capital to land ratio is greater than for food industry. Before any change in relative price, the expected output would change as given in the figure in part(b).

(d) As a result of increase in supply of capital stock which is an abundant factor for home country, it will produce more capital intensitive output which is cloth and this implies that price of cloth will increase with increase in supply so relative price of cloth will risemin the long run and the country which produces land intensive product will produce less now.

when trade occures between the two countries the relative prices tend to converge. Changes in relative prices would have a strong impact on factor prices. Home country will be net exporter of cloth and Foreign country will be importer of cloth. The following figure shows the impact of trade in the cloth industry of home with respect to foreign country.

(e)

when relative price of cloth rises, the PPF curve pivots towards the right as the home country has a comparative advantage in production of cloth wheres foreign country will produce food and its supply will decrease as the figure would depict because of increase in capital supply of cloth will increae.

hence, home country will export cloth and import food whereas foreign country will export food and import cloth.

(f) labor is a common factor for both goods but with an increase in capital stock would have an indirect effect in the labor market as more labor would be required to produce cloth. As there are diminishing returns of labor so the marginal productivity of labor would increase along with capital till a certain amount of output is produced after that there would be diminishing returns and capital per labour ratio will increase in the home country. Also, when more labor would be required so wages would increase as factor price increase when production expands. From price equalization theory, it implies that when price of factor intensive good rises then the price of the abundant factor also rises proportionally and labor being used along with capital will also lead to higher wages.