Question

Consider two countries, Spain and Italy, where the only two factors of production are capital and labor. Spain has 100 units of capital and 400 units of labor and Italy has 200 units of capital and 100 units of labor. Both countries produce two goods, cheese and suits. The labor share in total production costs is 75% for cheese but only 25% for suits. (2 points for each part)

A. Which country is labor abundant? Explain.

B. Which good is labor intensive? Explain.

C. What will happen to the relative price of cheese in Italy when the two countries open up to trade?

D. What will happen to the wage to rental rate ratio in Italy after opening up to international trade?

E. What will happen to the labor to capital ratio in the Italian cheese sector?

Answer 1

A. Spain is labor abundant country because it is bestowed with higher amount of labour which is 400 whereas,italy has only 100 units of labour. Therefore, it can be said that country which is blessed with higher labor will be known as labor abundant country.

B. Cheese is more labor intensive good because it requires higher amount of labour input for its production. Moreover it is given in the data that cheese requires 75% of the labor share in its production cost.

C. When the economy of both. Country will open the relative price of cheese in Italy will reduce. Since the Italy is capital abundant labor which means the labor availability is low which means it is costly to hire Labor due to its lack of availability. However after opening up its economy the relative price will reduce because they can import cheese from Spain which is cheap as conpacom to Italy because Spain is labor abundant country.

D. The wage to rental rate ratio in Italy after opening up to international trade will reduce. The main reason behind this phenomenon is that now cheese can be imported in Italy which has increased the competition of domestic seller of Italy. Moreover now the employee wage rate will reduce because their bargaining power has reduced due to availability of cheaper cheese which Spain will offer to Italy after opening up for international trade.