Question

Between Home and Foreign, which produce clothing and food. Clothing is capital intensive and food is labor intensive. Home is capital abundant and Foreign in labor abundant.

a. For Foreign, draw the two-panel graph we did in class. The left-hand panel includes the SS curve, which relates the relative price ratio (PC/PF) to the relative factor prices in left-hand panel (w/r). The right-hand panel includes the relative factor demand curves (CC and FF), which relate the relative factor prices (w/r) to the input ratio used in a country of labor to capital (L/K) in each industry. Is CC or FF farther to the right and why?

b. When trade opens, which good will Foreign export and how do you know?

c. Assume that the price is at (PC*/PF*) before trade (which you can draw anywhere on the axis). Show what happens to the graph you drew in part (a) when trade opens between the two countries. Indicate what happens to the factor price ratio and labor-capital ratios in each industry.

d. Using what you showed in part (c), show/explain what will happen to real rents and real wages in Foreign when trade opens.

Answer 1

1.

At any given wage-rental ratio, cloth production uses a higher capital-labor ratio (further to the right); so cloth production is capital-intensive and food production is labor-intensive.

2. If foreign is labour abundant it will have an advantage in exporting the labour intensive product. It will export food.

3.

Home is capital-abundant and Foreign is labour-abundant. Since cloth is the capital-intensive good, Home’s production possibility frontier relative to Foreign’s is shifted out more in the direction of cloth than in the direction of food. International trade leads to a convergence of relative prices, therefore the price of cloth relative to food will be equal. But the countries differ in their factor abundances. For any given ratio of the price of cloth to that of food, Home will produce a higher ratio of cloth to food than Foreign will. Home will have a larger relative supply of cloth. Home’s relative supply curve, then, lies to the right of Foreign’s.

Without trade, Home’s equilibrium would be at point 1 ( domestic relative supply RS = relative demand curve RD ). Similarly, Foreign’s equilibrium would be at point 3 but trade leads to a world relative price that lies between the two pre-trade prices, at point 2.

The factor price ratio increases in Home while it falls in foreign country as the relative price of cloth rises in Home and declines in Foreign.

4. In Home, where the relative price of cloth rises, people who get their income from capital gain from trade but those who derive their income from labour are made worse off. In Foreign, where the relative price of cloth falls, the opposite happens: Laborers are made better off and capital owners are worse off. So in foreign real wages rise and real rents fall.