Problem Set 3 Solution

1. According to the following table, which country is relatively more labor-abundant? Explain your
answer. Which is relatively more capital-abundant?

United States Canada

Answer: The capital-labor ratios are 1/5 and 1/6 for the United States and Canada. Since 1/5 is
greater than 1/6, the United States is capital abundant. By the same reasoning, the
labor-capital ratio is higher in Canada, so it is labor abundant.

2. Suppose that the United States and Canada have the factor endowments given in the table in
Question 1. Suppose further that the production requirements for a unit of steel is 2 machines
and 8 workers, and the requirement for a unit of bread is 1 machine and 8 workers.
a. Which good, bread or steel, is relatively capital-intensive? Labor-intensive? Explain your
answer.
b. Which country would export bread? Why?
Answers:
a. The capital-labor ratio to make steel is 1/4; to make bread it is 1/8. Hence steel is more capital
intensive and bread is more labor intensive.
b. Since the United States is capital abundant and steel is capital intensive, according to the
Heckscher-Ohlin trade model, the United States will export steel and Canada will export bread.

3. Suppose that before trade takes place, the United States is at a point on its PPC where it produces
20 loaves of bread and 20 units of steel. Once trade becomes possible, the price of a unit of steel is
2 units of bread. In response, the United States moves along its PPC to a new point where it is
producing 30 units of steel and 10 loaves of bread. Is the country better off? How do you know?
Answer: The United States is definitely better off because it can consume a greater quantity of
both goods. If it traded five steel for 10 bread it would have 20 bread and 25 steel. This
is the same amount of bread as before trade, and five more units of steel. It can keep the
extra five steel, or trade some or all of them for additional bread. In either case, the
consumption bundle is greater than it was before trade.

4. Given the information in Questions 1 and 2, explain what happens to the returns to capital and
labor in each country after trade begins.
Answer: The changes in the returns to capital are different by country. In the United States, the
demand for capital increases because more steel will be produced; conversely, the
demand for labor falls because of the drop in bread production. Owners of capital
benefit from the increase in demand for their inputs, while owners of labor suffer a
decline in their returns (wages). In Canada, the effects are reversed.

5. Suppose that there are three factors: capital, labor, and land. Bread requires inputs of land and
labor, and steel requires capital and labor.
 a. Which factors are variable, and which are specific?
b. Suppose Canada’s endowments of land and capital are 10 capital and 100 land, and the
United States’ are 50 capital and 100 land. Which good does each country export?
c. How does trade affect the returns to land, labor, and capital in the United States and in
Canada?
Answers:
a. Labor is the variable factor and capital and land are specific.
b. Canada is land abundant relative to the United States (100/10 is greater than 100/50), so
Canada’s comparative advantage is in the export of bread, the good with the specific input of
land. The United States’ comparative advantage is steel.
c. In the United States, owners of land are hurt by trade, owners of capital benefit, and the effects
on labor are indeterminate. The latter effect depends on labor’s preference for bread and steel.
In the United States, bread prices fall, but steel prices rise. In Canada, owners of land benefit
from trade, owners of capital are hurt, and the effects on labor are indeterminate. The latter
effect depends on labor’s preference for bread and steel. In Canada, bread prices rise, but steel
prices fall.

7. Does intrafirm trade contradict the theory of comparative advantage? Why or why not?
Answer: No, in general it does not, but it may in some cases. Most intrafirm trade can be
understood as a firm that cuts up its production process into several distinct stages,
and then relocates some or all of the stages to different countries where the factor
endowments are consistent with the production requirements of each stage. Labor-
intensive production stages will be relocated to labor-abundant countries, and so forth.
In this case, firms are taking advantage of the comparative advantage of different
nations in order to produce their goods at the lowest overall cost.
In some cases, however, there may be other motives for locating a production stage in
another country. These motives include the desire to avoid trade barriers by producing
all or part of a good inside the country where sales are anticipated, the desire to escape
taxation, the attempt to deter market entry by a rival firm, and as insurance against
unforeseen events (e.g., political instability).
8. Many domestically owned apparel manufacturers buy their garments overseas, sew their labels
into them, and then sell them abroad or back into the home market. What are some of the
considerations that a clothing manufacturer might go through to choose this strategy instead of
producing at home and exporting?
Answer: These firms perceive their asset to be their brand. This may involve some elements of
design (ordering specific output from foreign suppliers) but also could involve quality. It
can be based strictly on marketing and advertising, creating an image from something
that is in the end relatively cheap and easy to create. Allowing foreign firms the ability to
brand the clothes through licensing makes them lose control of this asset. Sewing labels
in allows some element of quality control while reducing production costs. Garment
assembly is relatively labor intense and low skill, making it more likely to occur in less-
developed, labor-abundant countries. Design, marketing, and access to high-spending
consumers are more likely to be assets of firms in developed countries. Owning an
assembly operation directly is not necessary for them to preserve this asset as long as
they have ultimate control over what they put their name on and how that product is
distributed and marketed.

9. Suppose Spain were to open its doors to a large number of unskilled Africans seeking to
immigrate. In general, what effects would you expect to see in Spain’s trade patterns and its
comparative advantage?
Answer: In theory, labor becomes more abundant and Spain’s comparative advantage could shift
to more unskilled, labor-intense production. In practice, this labor inflow may be used to
produce services that are not traded. They may free up citizens to work in the already
existing export sector and have little effect on comparative advantage.