Question

For this question, use the following specific factors model setup. There are two countries (Ethiopia and Pakistan) and two goods (potatoes and cars). Potatoes are produced with land and labour, while cars are produced with capital and labour. Both countries have the same amount of capital, but Ethiopia has more land. Solve everything in terms of potatoes.

a) Draw the RS curves for each country, as well as an RD curve. Use this diagram to help explain what happens to the relative price of potatoes in Ethiopia when it opens up to trade with Pakistan. Clearly label the pre-trade relative prices for each country and the post-trade relative price.
b) Using a well-labelled labour allocation diagram, explain what happens to the following things in Ethiopia when it opens to trade with Pakistan: labour in potatoes, labour in cars, real wages.
c) Draw a diagram that shows the gains from trade for Ethiopia when it opens up to trade with Pakistan.

Answer 1

The question discusses the effects of international trade on relative prices, labor allocation, and real wages in the context of Ethiopia and Pakistan producing potatoes and cars. Ethiopia would see a change in relative prices and an allocation of labor towards potato production with increased real wages due to trade. A diagram would also show the gains from trade, illustrating improved consumption possibilities.

Step-by-step explanation:

The question addresses the concept of international trade and its effects on production, prices, and labor allocation using a specific factors model. This involves two countries, Ethiopia and Pakistan, which produce two goods (potatoes and cars), with Ethiopia having more land while both countries possess equal capital.

To illustrate what happens to the relative price of potatoes in Ethiopia when it opens up to trade with Pakistan, one would need to draw the relative supply (RS) and relative demand (RD) curves for potatoes and cars in both countries. Ethiopia, with more land, is better suited for producing potatoes and thus would have a lower pre-trade relative price for potatoes compared to Pakistan. After opening to trade, Ethiopia would specialize in producing potatoes, the good for which it has more resources (land), and export them, leading to an equalization of the relative price of potatoes between the two countries at a level between their pre-trade levels.

Using a labor allocation diagram for Ethiopia, opening to trade would lead to an allocation of labor towards the potato industry, away from the car industry, assuming labor can freely move between industries. This would in turn lead to an increase in the real wages of labor due to the increased demand for labor in the potato industry.

Finally, a diagram showing the gains from trade for Ethiopia would depict how the country can now consume beyond its original production possibilities frontier, thanks to specializing in potatoes, which it exports, and importing cars, leading to an increase in both consumption and variety of goods available.