Question

Consider a Specific Factors model of a competitive economy in which 2 goods (Manufacturing products and Agricultural products) are each produced with a specific input (capital and land respectively) and labour is an input in the production of both goods.

1. Assume that the economy exports agricultural products. Use a PPF diagram with Agriculture on the vertical axis to illustrate this equilibrium and clearly show how much of each good is produced, consumed and traded.
2. Illustrate the impact on the equilibrium of an increase in the relative price of manufacturing goods that does not eliminate the economy’s comparative advantage in agricultural goods . Again, show amounts produced, consumed and traded.
3. Will this increase raise or lower the return to land? Explain your answer in detail.

Answer 1

Consider the given problem here T1T2 be the PPF of the economy, there are two goods “Manufacturing” and “Agricultural”. Now, initially the relative price is given by the blue line, => the production and the consumption points are “P1” and “C1” respectively. So, initially the country is exporting “P1A1” amounts of agricultural goods and importing “A1C1” amounts of manufacturing good.

Now, as the relative price of manufacturing goods increases implied the new relative price line is given by the red line. So, the new production and the consumption points are “P2” and “C2” respectively. So, the new level of export is “P2A2” amounts of agricultural goods and import is “A2C2” amounts of manufacturing good respectively. So, as the relative price of manufacturing goods increase the level of exports and imports both decreases.

Now, as the relative price of manufacturing goods increase which make the production of manufacturing goods more profitable. So, the all the produces wants to produce more of manufacturing goods and less of agricultural goods, which decreases the demand for “land”. So, the return on land decreases.