Question

Suppose there are two goods, Boats (B) and Flowers (F) and two factors of production labor and capital which are perfectly mobile between the two sectors. Suppose the production technology for Flowers is labor intensive and Home is a capital abundant country. When Home opens up to trade:

a. The relative price of Flowers will _________ (increase/decrease). Explain.

b. The relative return to capital will __________(increase/decrease). Explain.

c. The ratio of capital to labor will __________  (increase/decrease) in _________ (both sectors/Boats sector/Flowers sector). Explain.

Answer 1

Heckscher and Ohlin (HO) Theory of Trade states that factor endowments determine the international trade pattern. Basically, the HO Theory states that countries rich in capital should specialise in the production of capital-intensive goods and export the surplus. While those rich in labor should specialise in the production of labor-intensive goods and export the surplus. In our question, an extension of the HO Theory, that is, the Heckscher and Ohlin and Samuelson trade model, has been applied to determine the trade pattern after the economy opens.

Ans a.

In our question, HOME is capital abundant. In the absence of trade, labor which is relatively scarce than capital in HOME, would be priced higher than capital, that is, earn more rewards. However, this scenario will change once HOME opens up to trade.

As per the HO theory, HOME will produce the more capital-intensive good, boat, and export it to the world while importing its requirements of flowers from the world. The change in production patterns will cause the relative prices of the factors for HOME to change.

After opening up the economy, the price of labor (relative to capital) will decrease for HOME. This means that labor will now be relatively cheaper than capital. So, as flowers are a labor-intensive good, their prices will become cheaper for HOME.

Hence, the relative price of Flowers will decrease.

Ans b.

The HO and Samuelson Theory further states that the factor that is used more intensively in the production of the good that has become costlier than the other good, will experience increased rewards.

In our question, HOME has opened up the economy to trade and diverted production to the more capital-intensive good, boats and is exporting the same to the world while importing the labor-intensive good, flowers, from the world. As per the theory, capital - the factor used intensively in the production of boats, will gain from trade.

Hence, the relative return to capital will increase.

Ans c.

Because of trade, HOME will experience an increase in capital and a decrease in labor as it diverts resources to the production of boats. This means that HOME's capital to labor ratio will increase in the boats sector.

Hence, the ratio of capital to labor will increase in Boats sector.