Question

3. Heckscher-Ohlin theory. Assume there are two nations (1 and 2), two goods (X and Y), two factors of production (L and K). Commodity X is labor intensive, commodity Y is capital intensive. All assumptions are made following the standard H-O theory 3.1 Suppose nation 1 is L-abundant, and nation 2 is K-abundant. Please graph the production possibility frontiers of both nations. 3.2. What is the no-trade equilibrium in both nations? Please show on the graph and explain. 3.3. What is the equilibrium with trade? Please show on the graph and explain. 3.4. What will happen to wage and interest rate in nation 1 and 2 because of trade? 3.5 What will happen to the relative factor price (w/r) in nation 1 and 2 because of trade?

Answer 1

3.1) When nation 1 is labor intensive then it will lead to production of good X and in case of nation 2 there will be production of good Y. Below is the graph

N1 is the PPF of nation 1 and N2 is the PPF of nation 2.

As we can see the N1 graph is flat because more labor is used by Nation 1

There is a steeper graph for nation 2 that is N2 because it is capital intensive.

4 A Na. 3 e 20

3.2) The no trade points as per the graph is at point A and B .

It is point A for nation 2 and it is point B for nation 1

This is because the two countries would only trade when it gets maximum benefit from the trade without sacrificing the other good in production.

3.3) Equilibrium with trade refers to a point where the two countries get maximum of both the goods. In the particular graph the equilibrium is reached at point e. This is where both the country are producing at a constant price of the factors they are abundant in.

3.4) The wages in nation 1 which is labor intensive will rise whereas the interest rate on capital in the capital intensive nation 2 will rise.

3.5) The benefits will lead to price of labor price and capital price equalizing in both the nations.