Please use one graph per country and show both the autarky and the free trade equilibrium on each graph.
Consider the following data on the factor endowments of two countries A and B:
Countries
Factor Endowments
A
B
Labor force: L
100 workers
50 workers
Capital Stock: K
60 machines
10 machines
a. Which country is relatively capital abundant? Which country is relatively labor abundant? Explain (calculate the ratios).
b. Supposing that cars are capital intensive relative to shoes, which country will have comparative advantage in the production of cars? Of shoes? Explain.
c. Graphically demonstrate the pre-trade and post-trade equilibrium between these two countries (production and consumption points). Draw a Demand Diagonal. Find and label the trade triangles for each country.
d. Which factor gains and which factor loses when trade arises between these two countries? Explain precisely.
a. To determine which country is relatively capital abundant and labor abundant, we need to calculate the capital-labor ratios for each country. The capital-labor ratio is calculated by dividing the amount of capital by the amount of labor.
For country A:
Capital-labor ratio = Capital Stock / Labor force = 60 machines / 100 workers = 0.6
For country B:
Capital-labor ratio = Capital Stock / Labor force = 10 machines / 50 workers = 0.2
Comparing the two ratios, we can see that country A has a higher capital-labor ratio of 0.6, indicating that it is relatively capital abundant. On the other hand, country B has a lower capital-labor ratio of 0.2, indicating that it is relatively labor abundant.
b. Since cars are capital-intensive relative to shoes, the country that is relatively capital abundant (country A) will have a comparative advantage in the production of cars. This is because it has a higher capital-labor ratio, indicating a higher availability of capital relative to labor.
Conversely, the country that is relatively labor abundant (country B) will have a comparative advantage in the production of shoes. This is because it has a lower capital-labor ratio, indicating a higher availability of labor relative to capital.
c. To graphically represent the pre-trade and post-trade equilibrium between the two countries, we can use a production possibility frontier (PPF) graph. Each country will have its own graph, and we will plot the autarky and free trade equilibrium points on each graph.
First, let's draw a PPF graph for country A:
On the horizontal axis, we can represent capital stock (K), and on the vertical axis, we can represent labor force (L). Let's assume the production possibilities for cars (C) and shoes (S) are as follows:
- Autarky Equilibrium (AumA): Suppose in autarky, country A produces at point AumA, where it allocates more resources to the production of cars (C), resulting in a lower quantity of shoes (S).
- Free Trade Equilibrium (FTmA): After engaging in free trade, country A may specialize in the production of cars (C) and shift its production to point FTmA, where it produces more cars and imports shoes. This shift occurs due to the comparative advantage it has in car production.
Next, let's draw a PPF graph for country B:
Again, on the horizontal axis, we can represent capital stock (K), and on the vertical axis, we can represent labor force (L). Let's assume the production possibilities for cars (C) and shoes (S) are as follows:
- Autarky Equilibrium (AumB): Suppose in autarky, country B produces at point AumB, where it allocates more resources to the production of shoes (S), resulting in a lower quantity of cars (C).
- Free Trade Equilibrium (FTmB): After engaging in free trade, country B may specialize in the production of shoes (S) and shift its production to point FTmB, where it produces more shoes and imports cars. This shift occurs due to the comparative advantage it has in shoe production.
Overall, the Demand Diagonal shows the quantity of each good demanded by both countries in free trade. The trade triangles, labeled as ΔTA and ΔTB, represent the gains from trade for each country.
d. When trade arises between the two countries, the factors of production (capital and labor) will experience gains and losses.
For country A (capital-abundant):
- The capital gains from trade because it can specialize in producing cars, which is its comparative advantage. By specializing in car production and trading, country A can increase its total production of cars, allowing it to consume more cars than it could in autarky.
- The labor loses from trade because the production of shoes, where country B has a comparative advantage, may decrease. This could result in less employment opportunities for country A's labor force in the shoe industry.
For country B (labor-abundant):
- The labor gains from trade because it can specialize in producing shoes, which is its comparative advantage. By specializing in shoe production and trading, country B can increase its total production of shoes, allowing it to consume more shoes than it could in autarky.
- The capital loses from trade because the production of cars, where country A has a comparative advantage, may decrease. This could result in underutilization or decreased demand for country B's capital stock (machines).