International Economics Study Set 9

Business

Quiz 4 :
Who Gains and Who Loses From Trade

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Quiz 4 :
Who Gains and Who Loses From Trade

In the factor-price equalization theorem, it is assumed that it is a perfect competitive market. In the perfect competition market, the return to a factor of production depends upon the value of its marginal productivity. There are two factors in this market. They are labor and capital. As the amount of labor rises in an industry, the marginal productivity of labor will fall. As the amount of capital rises, the marginal productivity of capital will rise. Thus, the two countries face different prices for their output. The reason for this is the deviation between the wages and rents between the countries, because it affects the marginal productivity. When the free trade is allowed, the output prices will become equal in the two countries, because two countries face the same marginal productivity relationships. Thus, according to the factor-price equalization theorem, free trade will equalize the prices of goods and wages and real rental rates.

First, you might point out that stopping trading would also eliminate exports, so that many jobs would be lost in exporting industries. It is not clear that there would be a net gain in jobs, and any net gain would likely be small. In addition, total employment in the whole economy is essentially a macroeconomic concern that is best addressed through macroeconomic policies (the topic of Part Four of this book). Second, national well-being is much more than jobs. If we ended all trade, we would be giving up the gains from trade. Trade allows the country to sell some of its production as exports. These exports are used to pay for imports. Imports allow us to expand our consumption by giving us access to low-priced goods (and to goods that we cannot or do not produce domestically).

The Heckscher-Ohlin Model is based on the concept of comparative advantage in international trade. It states that countries should only produce and export those goods in which it has comparative advantage (or higher abundance) and import the ones it has higher cost (or lower abundance). As per the given question, trade between a land abundant and labor abundant country will leave the labor abundant country with lower rents and lower wages in the land-abundant country. This happens because demand for labor will fall in the land abundant country (leading to fall in wages) and demand for capital will fall in labor abundant country (leading to fall in cost of capital or rents). Thus correct option is (C).