Problem Set 2 Solutions

Econ 355 - Introduction to International Trade

2014-2015 Winter Term 1

True/False/Uncertain
1. False. If both Manufacturing and Agriculture goods prices decrease by 5%, the relative price does not
change (i.e. the new relative price is

Pm
Pa

Pm 0.95
Pa 0.95 ).

As a result, the allocation of labor in these two

industries remains unchanged. Thus, the real return to labor, which are determined by its marginal
product, does not change.
2. True. If

LS
L

>

KS
,
K

then we have

LS
LC +LS

>

KS
KC +KS .

Divide the numerator and denominator by LS on

the left hand side of the inequality, and divide the numerator and denominator by KS on the right hand
side of the inequality, we get

1
LC /LS +1

>

1
KC /KS +1 .

Hence,

KC
KS

>

LC
LS ,

i.e.

LS
KS

>

LC
KC .

Shoes is the

labor-intensive sector.
3. True. Suppose that in the short run unskilled workers are immobile while skilled workers are mobile in
the specific factors model. Then the unskilled workers stuck in the sector expanding due to trade would
gain in the short run. But those workers might lose from trade in the long run. To see that consider a
long-run Heckscher-Ohlin model with skilled and unskilled labor. If a country is skilled-abundant then
opening to trade reduces real wages of unskilled workers (regardless of their sector of employment).

Specific Factor Model

1. Properties of the Production Function
(a) For T = 16 we have:
M P LA (L = 1) = 4, M P LA (L = 2) = 2.8, M P LA (L = 4) = 2, M P LA (L = 6) = 1.6 and
M P LA (L = 8) = 1.4.
(b) T = 36 we obtain:
M P LA (L = 1) = 6, M P LA (L = 2) = 4.2, M P LA (L = 4) = 3, M P LA (L = 6) = 2.4, and
M P LA (L = 8) = 2.1.
(c) See Figure 1 below for function plots. M P LA function is downward sloping, so the production
function has diminishing marginal returns (i.e. M P LA is decreasing holding T constant). Notice
that marginal product of labor is higher when more land is used, at each level of labor input. So a
higher T increases the level of the M P LA function.

Figure 1: Marginal Product of Labor in Agriculture (M P LA ) for different values of T

MPLA
8
7

MPLA for T=4 (MPLA =

LA

MPLA for T=6 (MPLA =

LA

5
4
3
2
2

LA

2. Autarky Equilibrium
(a) We need to solve for LM and LA . Two conditions can be used:
1. The sum of the labor used in the two industries equals to the total labor endowment:
LM + LA = L = 41
2. In equilibrium, wage should be equal across sectors:
M P LM PM = M P LA PA
Knowing the M P L functions and PM = 2, PA = 1, we have

T
1 K

2=
1
2 LM
LA
substitute the values K = 100, T = 64 and square both sides
64
16
100
=
= LA =
LM
LM
LA
25
This equation together with the first condition provide the allocation of labor: LM = 25, LA = 16.
(b) Nominal wage of worker: W = M P LM PM = M P LA PA =
Real wages:

W
PM

= 1,

W
PA

=2

(c) Rental on capital: RK = M P KM PM =

1 LM
2
K

5
10

RK
PM

(d)

K
Real rentals on capital:
= 0.25, R
PA = 0.5

Rental on land: RT = M P TA PA = LTA 1

T
Real rentals on land: PRMT = 0.25, R
PA = 0.5

2=

4
8

= 0.5

= 0.5

1 K
2 LM

2=

10
5

=2

3. Trade Equilibrium
(e) Same as the autarky equilibrium, we use the following two conditions to solve for LM and LA :
1. The sum of the labor used in the two industries equals to the total labor endowment:
LM + LA = L = 41
2. In equilibrium, wage should be equal across sectors:
M P LM PM = M P LA PA
T
Knowing the M P L functions and world price PM
= 1, PAT = 1, we have

T
1 K

1=
1
2 LM
LA
substitute the values K = 100, T = 64 and square both sides
100
64
64
LM
=
= LA =
4LM
LA
25
substitute this equation into the first condition we get

89
25 LM

= 41, thus LM = 11.5 and LA = 29.5.

Compare with the autarky equilibrium, we can see that labor is allocated more towards LA as a
result of increase in the relative price of agricultural goods.
(f) Nominal wage of worker: W = M P LM PM = M P LA PA =
Real wages:

W
PM

= 1.5,

W
PA

1 K
2 LM

1=

10
2 11.5

= 1.5

= 1.5. Compare with the autarky equilibrium, the real wage in terms of

manufacturing goods increases while the real wage in terms of agriculture goods decreases.
(g) Rental on capital: RK = M P KM PM =
Real rentals on capital:

RK
PM

= 0.2,

RK
PA

1 LM
2
K

1=

11.5
20

= 0.2

= 0.2. Compare with the autarky equilibrium, the real rental

on capital in terms of both goods decreases. This is mainly caused by the drop in the marginal
product of capital as less labor are allocated to manufacturing industry.
(h) Rental on land: RT = M P TA PA =
Real rentals on land:

RT
PM

= 0.7,

RT
PA

LA
T

1=

29.5
8

= 0.7.

= 0.7. Compare with the autarky equilibrium, the real rental

on land in terms of both goods increases. This is mainly caused by the rise in the marginal product
of land as more labor are allocated to agriculture industry.
(i) After opening to trade, the real wage in terms of manufacturing goods increases while the real wage
in terms of agriculture goods decreases. Whether a worker is better or worse of depends on her
consumption bundle: the ones that purchase mostly manufacturing goods gain from trade while
those purchasing mostly agriculture goods lose. The owners of capital lose from trade as a result
of the drop in both real rentals on capital, given the decrease in the relative price of manufacturing
goods. Finally, the owners of land gain from trade since both real rentals of land rise, given the
increase in the relative price of agriculture goods

Data exercise
1. The number of employees in the entire economy of Portugal in 2005, given by the measure EMP, is
5,100,000. In Netherlands, it is 8,251,595. The real fixed capital stock in the entire economy of Portugal
in 2005, given by the measure K GFCF, is 343,547 [in millions of Euros]. In Netherlands, it is 1,409,754.
Since the ratio K/L is greater in Netherlands (170 > 67 [in thousands of Euros per employee]), Netherlands
is the capital abundant country and Portugal is the labour abundant country (since equivalently the ratio
L/K is greater in Portugal).
2. First, consider the data for Portugal in 2005. The number of employees in the textiles sector is 225,200,
while the real fixed capital stock in the same sector is 4,099. For the sector of electrical and optical
equipment the number of employees is 46,200, while the real fixed capital stock is 3,480. Since the ratio
K/L is greater in the sector of electrical and optical equipment (75 > 18), this sector is capital intensive
in Portugal, whereas the textile sector is labour intensive. Now, consider the data for Netherlands in 2005.
The number of employees in the textiles sector is 20,247, while the real fixed capital stock in the same
sector is 1,584. For the sector of electrical and optical equipment the number of employees is 84,689, while
the real fixed capital stock is 9,183. Since the ratio K/L is greater in the sector of electrical and optical
equipment (108 > 78), this sector is capital intensive in Netherlands, whereas the textiles sector is labour
intensive. The ranking of sectors is the same in both countries.