Show graphically and explain how a policy that increases the productivity of the labor input in a labor abundant country affects the equilibrium terms of trade between that country and a capital intensive country (assume that L and K are the only inputs and that the countries trade 2 goods – X, a labor intensive good and Y a capital intensive good). You will need to use offer curves to answer this question.
To understand how an increase in labor productivity in a labor-abundant country affects the equilibrium terms of trade, we need to analyze the offer curves of both countries.
The offer curve represents the combinations of goods that a country is willing to export at different relative prices. In this case, the labor-abundant country exports the labor-intensive good (X), while the capital-intensive country exports the capital-intensive good (Y).
Let's assume that initially, the labor-abundant country has a lower labor productivity compared to the capital-intensive country. This means that the labor-abundant country needs to use a larger amount of labor to produce the same quantity of goods compared to the capital-intensive country.
In this scenario, the offer curve for the labor-abundant country (Country A) will be steeper than the offer curve for the capital-intensive country (Country B). This is because Country A needs to allocate more labor to produce the same quantity of goods as Country B.
Now, let's consider the impact of an increase in labor productivity in the labor-abundant country (Country A). This increase means that Country A can now produce more output with the same amount of labor, resulting in a flatter offer curve.
A flatter offer curve implies that the labor-abundant country (Country A) can now produce and export more of the labor-intensive good (X) at any given relative price. Consequently, the labor-abundant country will be able to supply more X at every price level.
On the other hand, the offer curve for the capital-intensive country (Country B) remains unchanged since its productivity has not been affected. Therefore, the offer curve for Country B will be relatively steeper compared to the new flatter offer curve of Country A.
As a result of the increased labor productivity in the labor-abundant country, the terms of trade between the two countries will change. The terms of trade refer to the rate at which the countries exchange their goods.
With the increase in labor productivity, the labor-abundant country (Country A) can now produce more of the labor-intensive good (X) and export it to the capital-intensive country (Country B). This increased supply of X puts downward pressure on the relative price of X. As a result, the terms of trade will shift in favor of the labor-abundant country, leading to a higher quantity of capital-intensive good (Y) from the capital-intensive country.
Graphically, this can be represented as a shift in the equilibrium terms of trade towards the labor-abundant country. The new equilibrium terms of trade will reflect a higher quantity of Y being imported by the labor-abundant country in exchange for its increased supply of X.
It is important to note that this analysis assumes that there are no other factors influencing the terms of trade, such as changes in demand or other production factors. The explanation provided highlights the impact of increased labor productivity in a labor-abundant country on the equilibrium terms of trade with a capital-intensive country.