Question

1. Assume Home produces 2 goods, clothing (C) and food (F). Clothing is produced using labor (L) and capital (K), while food is produced using labor (L) and land (T). The total supply of labor, capital, and land are 1,200, 1,000, and 1,600, respectively. Labor is mobile across sectors. All markets are competitive. Home’s production functions for clothing and food are given by:

QC = LC K^{1/3 2/3}

QF = LF T^{1/2 1/2}

Now suppose there is another country, Foreign, which has a larger supply of clothing than Home. Home and Foreign open up to free trade.

a. Describe the trade pattern between Home and Foreign.

b. What is the effect of trade on Home’s relative price of clothing?

c. Show graphically how labor allocation and wage respond to free trade in Home.

d. Describe the income effects of trade in this example (Who will gain and who will lose?).

Answer 1

[a]Foreign has a larger supply of clothing than home. Given this the relative price of clothing [pc/pf] will be lower in foreign than in home. When both are open for free trade world price of cloth will be higher than relative price of cloth in foreign. Hence foregn will export cloth to home and home will export food to foreign.

[b]Due to trade home's relative price of clothing will be lower than world relative price of clothing and hence it will import cloth.

[c]After trade as home will export food, the labor allocated to food swctor will increase and hence the wages of labor in food sector will increase.

[d] After trade, the factor specific to export sector [capital in case of Foreign and land in case of Home] will gain and the factor specific to import sector[Land in case of foreign and capital in case of Home ] will lose whereas the mobile sector labor's welfare is ambiguous.

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