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 capitalintensive; A is capital-abundant. Analyze the effects on the terms of trade and on the two countries' welfare of the following: 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 \(\mathrm{B}\) 's labor supply.

Short answer

a. A’s capital stock increase improves A's terms of trade and welfare. b. A's labor supply increase dilutes its capital abundance, potentially worsening A's terms of trade and welfare. c. B’s capital stock increase might improve B's terms of trade and welfare, similar to A. d. B's labor supply increase further accentuates its labor abundance, potentially reducing its terms of trade and welfare.

Step-by-step solution

- Analyzing the increase in Country A's capital stock

According to the Heckscher-Ohlin model, a country will export the good which uses its abundant factor more intensively. Since country A is capital-abundant and good X is capital-intensive, an increase in capital stock will increase A's comparative advantage in producing good X. Consequently, the production of X will rise, leading to an increase in exports of good X. This could potentially improve the terms of trade for country A, as it can command more of good Y per unit of exported X, thus potentially improving country A’s welfare.

- Impact of an increase in Country A's labor supply

If the labor supply in country A increases, it will dilute the capital abundance slightly, potentially making labour relatively cheaper. However, as technology and capital abundance is the same and X is capital-intensive, the impact on the production of X might be minimal compared to the impact on Y. Country A might experience a decrease in the terms of trade if it starts exporting more of the labor-intensive good Y than before, possibly decreasing welfare due to a less favorable trade of X for Y.

- Effects of an increase in Country B's capital stock

Country B, having the same technology and presumably being labor-abundant, will see an increase in its capital stock. This will decrease its relative labor abundance. Assuming country B is initially specialized in producing the labor-intensive good Y, the increase in capital can lead to an increased production of the capital-intensive good X. This dynamic could improve B's terms of trade if it can export more of good X, and it could lead to an increase in country B's welfare, parallel to the case with country A's capital stock increase.

- Analyzing the increase in Country B's labor supply

An increase in the labor supply of country B will reinforce its position as a labor-abundant country assuming that the country is initially labor-abundant. With the extra labor, the production of the labor-intensive good Y may increase, which leads to more exports of Y. This can have a negative or positive effect on the terms of trade, depending on the global demand for Y, but could potentially reduce the terms of trade and welfare if there isn't a proportional increase in demand for good Y.

Key concepts

Factor Endowments

Factor endowments refer to the quantity and quality of production factors—capital and labor—that a country possesses. In the Heckscher-Ohlin model, the distribution of these factors plays a pivotal role in determining a country's export and import behavior.

The model posits that a country will tend to export goods that utilize its abundant factors more intensively and import goods that use its scarce resources. For instance, a capital-abundant country like A in the exercise shifts towards producing and exporting more capital-intensive goods, such as good X, after an increase in its capital stock. Consequently, this change in factor endowments will affect both the country's terms of trade and overall welfare.

Terms of Trade

The terms of trade is a measure that reflects the relative prices of a country's exports in terms of its imports. It is crucial in the international trade context because it indicates how many imports can be received for a unit of exported goods.

In the Heckscher-Ohlin framework, changes in factor endowments like an increase in the capital stock of a capital-abundant country can improve its terms of trade. Country A might export more of the capital-intensive good X and as a result, receive more imports per unit of export, enhancing overall welfare. Conversely, if a country starts exporting more labor-intensive goods due to an increase in labor supply, its terms of trade may worsen if these goods are less valued internationally.

Comparative Advantage

The concept of comparative advantage is fundamental in international trade theory, suggesting that countries benefit from specializing in and exporting goods and services they can produce relatively more efficiently than others.

In the textbook exercise, country A has a comparative advantage in producing the capital-intensive good X. The increase in A's capital stock further strengthens this advantage, enabling A to specialize and potentially increase its welfare through trade. On the other hand, when country A's labor supply rises, it could slightly shift their comparative advantage towards labor-intensive goods, potentially lessening the benefits of international trade for A.

Capital-Intensive Goods

Capital-intensive goods are products that require a higher proportion of capital relative to labor in their production process. These goods often involve more machinery or more technologically advanced processes.

In our exercise, good X is capital-intensive. An increase in A's capital stock leads to a lower cost of producing good X. As such, A can produce more of X, and if A exports this good, the country's wealth potentially increases due to favorable changes in trade balances and terms of trade.

Labor-Intensive Goods

Labor-intensive goods are ones that require a larger amount of labor compared to capital in their production. These are typically less technologically advanced and require manual labor. In this scenario, good Y is likely labor-intensive.

When country A's labor supply increases, it may produce more of labor-intensive goods like Y. However, without a corresponding increase in global demand for Y or if Y has lower value on the international market, it may lead to decreased terms of trade and hence, might not favorably affect A's welfare.

International Trade Welfare

International trade welfare refers to how the well-being of a country is affected by its participation in international trade. This is influenced by the terms of trade and is reflected in the standard of living, income distribution, and economic growth.

In our exercise, changes in capital stock and labor supply impact the welfare of countries A and B. For A, improved terms of trade associated with capital stock increase can lead to better welfare. For B, the impact is ambiguous, dependent on how the increase in labor or capital affects its production and export structure, highlighting the importance of aligning factor endowments with global market demand to maximize welfare through trade.