Question

2. Consider that China (and to a somewhat lesser extent India) has moved from relative autarky to relative openness in a short period of time (30 years or so). Suppose both countries are relatively abundant in labor, compared with the rest of the world. The rest of the world is relatively abundant in land. Let there be two tradeable goods: manufacturing, which is labor intensive, and food, which is land-intensive.

2a. Use a relative supply – relative demand graph to demonstrate the effect of a movement by China and India from autarky to free trade on the rest of the world’s terms of trade (manufacturing relative to food). (10 points)

2b. Suppose that the world has two factors (labor and land). Using the Heckscher-Ohlin model, describe the consequences of China and India’s entry for the wage paid to labor in the rest of the world. What does the model predict about the impact on wages in China and India? (10 points)

2c. Suppose that a country like Mexico was an exporter of labor-intensive manufacturing before China and India began trading, and remained a labor-intensive exporter after China and India began trading. Use the standard trade model to represent the changes in Mexico’s production and consumption outcomes as a result of the changes. (20 points)

Answer 1

Given, China and India are abundant in labor, whereas rest of the world in land. Manufacturing is labor intensive and food is land intensive.

a)Once China and India shifts from autarky to free trade, there will be more supply of manufacturing products relative to food. This is because these 2 countries are labor intensive. So, once they open up, they will be exporting manufacturing products. So, relative supply of manufacturing relative to food increases. As a result, relative price of manufacturing also falls. So, terms of trade of rest of the world rises because relative price of food rises.

Graphically shown below:

Y represents relative price manufacturing products before free trade. Y* represents the relative price after trade.

b)Hecksher Ohlin Model states that country exports the good which is factor intensive in the relatively abundant factor. So, China and India exports manufacturing goods because it is labor intensive. So, after these 2 countries open up, we see that relative price of manufacturing fall in rest of the world. Given that marginal productivity of labor does not change (in short run), wages also fall in rest of the world (because wages= price of commodity*marginal productivity).

After opening up, China and India will get a higher price for manufacturing goods because they'll sell it in high priced international market. So, returns to labor and hence, wages will rise in these 2 countries.

c) Graph is shown below:

As is evident, before the price line was Pm/Pf. At this price level, mexico produced at A' and consumed at A. It also exported manufacturing goods, which is also shown in the graph. After China and India enters the market, relative price of manufacturing falls, so the price line become less steeper at (Pm/Pf)'. Still, Mexico decides to export manufacturing. So, both the quantity of exports and imports of commodities in mexico falls. Now, at new price line, mexico consumes at a lower level B and produces at B'. We also see that due to fall in relative price level, Mexico now produces more of food and less manufacturing goods.