Question

Imagine the case of a small open economy (in the way that this country’s actions cannot modify international relative prices) that produces good X (labor intensive) and good Y (capital intensive). This hypothetical country is Labor abundant. Assume that there is a sudden increase in investment, so that there is more available capital in this economy. What theorem or concept would you use to explain the effects on the production of X and Y? Carefully explain what would happen with optimal production of X, Y and amount traded of both goods. Show the situation using Production Possibilities Frontier graphs.

Answer 1

As we can see that the country is initially producing Q1 quantity of labor - intensive good X and Q1' quantity of good Y. Since the country is labor abundant it will tend to produce more of x and less of y, which requires capital.

After increase in investment, now that the country has more capital, the production of good Y will increase, whereas production of X will decrease. We can see that in the production possibility frontier, which has moved up where Q2' of Y and Q2 of X is being produced.

answered by: anonymous