Question

Consider an economy in which two factors of production, labor and capital, produce two goods, capital intensive pharmaceuticals and labor-intensive clothing. Suppose that both factors of production are freely mobile across both industries and that all producers, consumers, capitalists and workers are price-takers. Suppose that there are currently steep tariffs on all imported goods, but there is a bill before Parliament to eliminate those tariffs, and the government has invited citizen representatives of workers and capitalists to express their opinions on the matter. Suppose that all citizen representatives understand the consequences of eliminating the tariffs, and suppose as well that each representative simply wants to maximize his or her real income. The parliamentary hearing takes testimony from four groups, representing workers in the clothing industry, capitalists in the clothing industry, workers in the pharmaceutical industry, and capitalist in the pharmaceutical industry, respectively.

a) If this economy is capital-abundant relative to the rest of the world, which of these four groups do you expect to support the tariff elimination bill, and which do you expect to oppose it? Why?

b) Now, suppose that the country is labor abundant relative to the rest of the world, and answer the same question, explaining any differences there might be with the previous answer.

c) How would your answer now change if, instead of being freely mobile, we assume that both labor and capital are sector-specific (cannot move between sectors)?

Answer 1

Hi there!

Some Basics:
So the fundamentals of this question are based around the Cobb Douglas Function of production which is F(K,L) = K^αL^1-α. This means that either factors of production can be devoted to K (capital) or L (labor). If you devote more capital to the function, you'd produce more pharmaceuticals and if you devoted more labor to the function, you'd produce more clothing.

Moving Deeper into the Question:
The next step is to look further at the assumptions in the problem, "the factors of production are freely mobile and all the people involved in the process are price takers." These assumptions are important because the last one implies that the country does not make the price which is means that they live in a free market system and they cannot dictate the price so any flood of imports will severely limit the profits of one industry or another while benefitting by the area not effected by the increase in imports. The freely mobile factors of production is the star of the show as it states that each factor of production can be used in either pharmaceuticals or clothing (so all the inputs [raw materials, time, man hours, rent and wages] are considered fairly equal in terms of costs and relative efficiency).

Meat and Potatoes:
Here's where it gets interesting as each factor of production is divided into workers and capitalists; so we need to add another aspect into our Cobb-Douglas Function which is a function for cost. F(Cost) = ([wages * labor] + [rent * capital]) which is simplified into F(C)=wL+rK. However, the higher the cost functions are negatively impact the revenue of the capitalists because more costs mean less money coming into Mr. BigCat's pockets. Thus, when thinking about part (A) and (B), think about the increased prices (good for laborers as the capitalists will need to increase wages in order to keep their workers from either leaving to work abroad or leaving to work at the other industry (clothing or pharmaceuticals)) and decreased revenues (bad for capitalists as potentially cheaper goods will force them to lower prices to the world price which hurts their bottom line) in terms of the new tariff reduction bill. If the world is more capital abundant, they're better at making x which means they can do it at a cheaper cost which would hurt one of the players in the capital-intensive sector.

More Meat and Potatoes:
For Part (C), this is where understanding the freely mobile factors of productions is really important. Previously, workers in either sector could move fairy freely back and forth between clothing and pharmaceuticals. Now, if the factors of production are more sector specific, they won't be able to transfer their skills over to the sector which means, they may be more reticent to a new rush of imports because then they would have more trouble finding work. That brings us to part

(D) which you can think of like the automotive industry within the US especially since the rise of other European export cars (personally, I like my cars Italian and fast, fill in the blanks) anyways, with that rise in European imports, many people in car-making sectors in the country felt like their entire livelihoods were threatened because they felt their skills were not mobile enough to either move or find another job.

Thank you, I hope you like this answer. please support me give a thumb up.