Question

Consider two countries, Home and Foreign, engaged in free international trade. Each country produces two products, A and B, using Capital (K) and Labour (L). Capital and Labour are mobile between sectors, but are immobile internationally. Home exports product A, which is relatively capital intensive in production.

Home experiences growth in the form of an increase in its capital stock. The following questions ask you to explain various consequences of this growth. In doing so, you must provide your detailed reasoning in each answer.

(c) Explain what happens to the real income of Home’s labourers as a result of the growth and subsequent terms of trade change.
(d) Do Foreign’s labourers experience the same effects on their real incomes, or is their experience different? Explain your answer.

Answer 1

( c )

As Home exports product A which is relatively capital - intensive in production, the country experiences growth in the form of an increase in its capital stock. Increase in capital stock in Home would enable it to produce product A more productively than before, or in other words an increase in capital stock would increase productivity ( increase in output per unit of labor ) of laborers in Home, thereby leading to an increase in real income of Home's laborers.

( d ) Foreign's laborers will also experience the same effects on their real incomes as there is factor mobility between sectors which will lead to laborers in foreign move to produce product A which will lead to capital accumulation, increase in productivity and subsequently an increase in their real income