Question

Assume that the United States and Cambodia both have similar demand functions and similar taste preferences. The United States however is capital abundant while Cambodia is labour abundant. Assume that the two countries produce only two goods: capital-intensive cars and labour-intensive shoes. Currently, the two countries are in the process of negotiating a bilateral free trade agreement (FTA). Part (a) Use the concepts of supply and demand to illustrate the situation of bilateral trade between the United States and Cambodia before the creation of their FTA. Note that before the creation of the FTA, both the United States and Cambodia use import tariffs. How can the Heckscher-Ohlin model be used to explain the positions taken by capital owners and labour owners in each country vis-à-vis a USA-Cambodia FTA. Students are recommended to use graphs in their answer. [7 marks] Part (b) If an FTA between the United States and Cambodia is created, according to the Heckscher-Ohlin model what will happen to the total welfare of each country? Specifically, use the concept of Production Possibility Frontier (PPF) to graphically show the changes in the welfare of both countries following the creation of their FTA. [5 marks]

Answer 1

Country	Abundant factor	Scarce factor
U.S	capital	Labour
Cambodia	Labour	Capital

• Since U.S is a capital abundant country it produce and export more capital intensive cars. Supply of car in U.S is high because it is cheap in U.S.
• Since Cambodia is a labour intensive country it produce and export more labour intensive shoes. Supply of shoes in Combodia is high because it is cheap in Combodia.
• Before negotiating a bilateral free trade agreement(FTA) both countries used import tariff; tariffs are used to restrict imports of the country by increasing the price of goods and services purchased from other country. So while imposing import tariffs price of the commodity increased and it will cause decrease in demand and subsequent reduction of supply.
• Because of capital abundancy U.S have high supply of capital intensive cars and demand shoes. In case of Combodia because of labour abundancy they have high suppy of shoes and they need more cars before FTA.
• Through FTA both country can import and export goods without any restrictions like import tariff, duties etc.
• Based on Heckscher-Ohlin model countries will specialise in the production and export of the cheap priced factor endowment because of its relative abundance in respective countries. Through FTA capital owners will produce and export more capital intensive cars and labour owners will produce and export more labour intensive shoes.
• If a FTA between U.S and Combodia is created according to Hecksher-Ohlin model totel welfare of each country will increase through producing and exporting their own factor intensive products without any restrictions in trade.
• A production possibility frontier (PPF) shows different combinatin of two commodities produced by a country with its fixed resources and technology.h