Countries A and B have two factors of production, capital and labour, with which they produce two...

Question:
Countries A and B have two factors of production, capital and labour, with which they produce two goods, X and Y. Technology is the same in both countries. X is capital intensive; A is capital abundant. Analyze the effects on the terms of trade and the welfare of the two countries. Use diagrams in your analysis.

A) An increase in B’s capital stock.

B) An increase in B’s labour supply.

Terms of trade
The terms of trade are the trade price ratio. The ratio of export pricing to import pricing defines the terms of trade of that country. Higher exports and production of the country leads to positive terms of trade for that country.(转载于留学作业帮www.homeworkhelp.cc)

Answer and Explanation:

In this scenario, the production of X is capital intensive, and country A is capital abundant. Hence, it is clear that country A would produce more of X and less of good Y. Country A would have more efficiency and hence, surplus production of good X. Thus, A would export X to B. Country B would import Y.

A)

If there is an increase in the capital stock of country B, country B can produce more of good X than good Y. Country B would not have sufficient stock of X and would reduce the imports from country A. Hence, its import prices fall, and export prices would rise. Country B has positive terms of trade (TOT) than country A. The welfare of country B increases, and that of A falls.

In the above diagram, the X is measured on the horizontal axis and Y on the vertical axis. OB curve is the offer curve of country B, and the OA curve is the offer curve of country A. OP is the ratio of terms of trade. As the capital stock of B increases, production of X increases in B from q1 to q2. Offer curve OB shifts to OB1. Hence, TOT favor B, from OP1 to OP2.

B)

If there is an increase in the labor supply of B, then B is not capable of producing X more, and hence would produce Y more. B would now have to import X more from A. thus, the import prices of B rise more than the export price of B. Country B has lower terms of trade. Country A has higher terms of trade as it exports more. The welfare of country B would fall, and the welfare of country A would rise.

In the above diagram, the increase in labor supply of B leads to a fall in production of good X in B, from q1 to q2. Offer curve shifts downward, OB to OB1. TOT worsens in B, from OP1 to OP2.