Question

Countries A and B have two factors of production, capital and labor, with which they produce two goods, X and Y. Technology is the same in the two countries. X is capital-intensive; A is capital-abundant. Using the standard trade model (USE GRAPHS OR EQUATIONS IF NEEDED) analyze the effects on the terms of trade and on the two countries’ welfare of the following: (PLEASE USE YOUR OWN ANSWER, EXPLAIN THOROUGHLY with graphs or equations.)

(a) An increase in A’s capital stock.

(b) An increase in A’s labor supply.

(c) An increase in B’s capital stock.

(d) An increase in B’s labor supply.

Answer 1

*Answer:

Step-by-step solution

1. Step 1 of 9

   The answer to the question is based on Heckscher-Ohlin theory, which assumes that there are two factors which are used to produce two goods. Further, there is difference in the factor intensity which leads to rise in the trade between two nations. It is assumed that Country A is capital intensive and country B is labor intensive.

   Comment

2. Step 2 of 9

   According to the famous Heckscher-Ohlin theory, an economy will export the good which uses the economy’s relatively abundant factor intensively. In the given question, Country A is capital abundant and good X is a capital intensive good. Thus, the country A will specialize in the production of good X and export the surplus units to country B. Country B is labor abundant and it will specialize in the production of good Y and export the surplus units to country A and import good X from country A.

   Comment

3. Step 3 of 9

   The term of trade is used to depict the existing price ratio,between two nations involved in a trade.

   In international trade, the term of trade is the price ratio of exported good to the price of imported good. Thus, the terms of trade can be expressed as:

   Comment

4. Step 4 of 9

   The situation in countries A and B complies with biased growth. Growth is biased when it shifts the production possibility frontier of a country out more towards one good than towards the other. For instance, an increase in labor increases the production of good Y, which is labor intensive; on the other hand, an increase in capital increases good X which is capital intensive.

   Comment

5. Step 5 of 9

   However, the direction of the terms of trade effects depends on the nature of the growth.

   Export-biased Growth: It worsen the terms of trade of the growing country and leads to improvement in terms of trade of trading partner country.

   Import-biased growth: It improves the terms of trade for the growing country and may deteriorate the terms of trade of trading partner country.

   Comment

6. Step 6 of 9

   (a) Since growth in country A is export-biased, A’s terms of trade worsen. A’s welfare may increase or decrease while B’s welfare would increase.

   Comments (1)

7. Step 7 of 9

   (b) Since growth in country A is import-biased, A’s terms of trade improve. A’s welfare increases while B’s welfare decreases.

   Comment

8. Step 8 of 9

   (c) Since growth in country B is import-biased, B’s terms of trade improve. B’s welfare increases while A’s welfare decreases.

   Comment

9. Step 9 of 9

   (d) Since growth in country B is export-biased, B’s terms of trade worsen. B’s welfare may increase or decrease while A’s welfare would increase.

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