Capital Abundant

Capital Abundant

Two countries, France (F) and Germany (G) produce two goods, cars (C) and wine (W). France has 2050 units of capital and 916 units of labor. Germany has 816 units of capital and 270 units of labor. In France, 926 units of capital and 618 units of labor are employed in the wine industry. In Germany, there are 366 units of capital and 135 units of labor employed in the wine industry.

a. Which country is labor abundant? Which country is capital abundant? Which good

Labor intensive? Which good is capital intensive?

Given the above information we can summarize the above information in a table as follows; this table assumes that there are no idle resources.

France

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Capital Abundant

Germany

cars

wine

total

cars

wine

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Capital Abundant

total

capital

1124

926

2050

450

366

816

labor

298

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Capital Abundant

618

916

135

135

270

From the above table it is clear that France is capital abundant due to the high number of capital

In both countries the cars use more units of capital, therefore we can conclude that cars are capital intensive goods, on the other hand it is evident that wine uses less capital in production

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than the cars and therefore it can be termed as a labor intensive good.

b. Assume identical preferences and technologies between the two countries. Use Graphical analysis to present the autarky equilibrium in each country. Which country will have lower relative price of wine in autarky?

Autarchy can be defined as the state of an economy whereby the economy does not take part in trade, the country produces all the goods demanded internally and therefore we consider a closed economy in this analysis of the two countries:

The production possibility curve can be analyzed as follows for each country:

The above diagram shows the production possibility frontier for France and Germany, the autarchy equilibrium is determined by the point where the income constraint line touches the production possibility frontier; the slope of this line is given by dividing the price of cars by the price of wine.

The gradient of the income line helps us determine in which country prices for wine are higher,

according to the gradient of the income line it is clear that wine in Germany is less expensive

than the price of wine in

France

, Therefore Germany

has a lower relative price of wine.

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Capital Abundant

c. Use graphical analysis of the relative demand and relative price of labor in terms of capital for each industry to show how the equilibrium relative price of labor and the equilibrium relative quantities of labor in each industry are determined in Germany:

The following table summarizes the demand for capital and labor in the car and wine industry:

Germany

cars

wine

total

450

6/10

Capital Abundant

366

816

135

135

270

From the above chart it is clear that the demand for labor is equal in each industry, however the car industry will demand more capital than in the wine industry and therefore in Germany car production is capital intensive while wine production is labor intensive.

Given the amount of labor and capital used up in both industry we can get the relative price of labor in both industry, in the car industry the relative price of labor is 450/135, in the wine industry we can get the relative price of labor as 366/135, the table below summarizes the relative prices:

cars

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Capital Abundant

wine

capital

1

1

labor

3.333333

2.711111

The above diagram shows the production possibility frontier in both industries, the budget line determines how much each industry is to demand both labor and capital, in the wine industry labor is relatively cheaper and therefore more labor is demanded to substituted capital, in the car industry the price of labor is relatively higher and therefore less labor is used and therefore more capital is used to substitute labor. The slope of the production possibility curve gives us the marginal rate of substitution, for this reason therefore we can therefore conclude that the optimal point of production and quantity of labor and capital to be used is determined by the production possibility curve and the budget line.

d. Suppose now that the countries open to trade. What will happen to the relative price of wine in Germany? Show the new trade equilibrium in Germany on your graph. Clearly

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indicate how much wine will be produced and consumed in Germany after the country opens up to trade. What is the good that Germany will Export?

The following diagram shows a situation where the countries open up for trade,

The two parallel red lines show the new tangent to the production possibility curve and the points that the two curves tough is the same point the utility function touches the PPF, France will now import A – B cars and export E – G units of wine, Germany will export C –D units of cars and import F –H units of wine.

e. Use your results from part “d” to state the Heckscher-Ohlin Theorem, which relates a country’s export to factor intensity and labor abundance.

The Heckscher Ohlin Theorem states: With two goods and two factors, each Country will export the good that it has relative efficiency in production; a labor abundant country will export labor intensive goods and import capital intensive goods. On the other hand a capital abundant country will export capital intensive goods and import labor intensive goods.

f. Use graphical analysis to show the effects of trade on the relative factor prices and relative factor demands in Germany. Put relative wage on the Y-axis and the relative labor on the X-axis. Write a clear statement about the direction of the relative factor price change and the changes in the relative labor demand in each sector.

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Capital Abundant

According to the factor price equalization theory when factors of production cannot move freely between countries while good can then the free movement of goods will result to the equalization of factor prices, in the car industry the price of labor is higher than in the wine industry, for this reason therefore when there is trade the wage rates in both countries is equalized and therefore in both the car and wine industry prices will be the same as shown in the diagram above.

References:

Charles Marrewik (2000) International Trade and the World Economy, McGraw Hill publishers, New York

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