Consider the following Specific Factor Model setup: Terraria, a small economy, h

Question

Consider the following Specific Factor Model setup: Terraria, a small economy, has two production sectors, Farming (W) and Mining (D). It uses land (T) and workers (L) to farm wheat. Mining for diamonds takes capital (K) and workers (L), so that workers can be employed in either of the two sectors. Perfect competition hold in all markets. The economy is open to trade and faces world prices pW for wheat and pD for diamonds.

(a) Additional demand on world markets causes the price of diamonds to increase, pD . Describe the consequences of this change for (i) the share of workers employed in Mining, (ii) the output of the Farming and Mining sectors, and (iii) the welfare of the 3 factors of production (which of them is better/worse off). In studying the welfare consequences for Workers, assume that they never purchase any diamonds.

(b) An entrepreneur wants to bring in new boring machines and open a new diamond mine in Terraria. This would increase the number of capital units (K) operating in the country. Since this development project is expected to potentially impact everyone’s lives, the government decides to submit the proposal to a vote. Assume that everyone will vote in their narrowly-defined economic interest, i.e. that they only care about their own welfare, with no regard for others’. Explain how landlords, incumbent capitalists, and workers would vote.

Explanation / Answer

a. Increase in the price of diamonds will increase the profits of sellers and hence number of workers employed in mining will increase. This will increase the output of mining sector and since the number of workers employed in farming will decrease, the output of farming sector will decline. Wages in mining sector will increase. Workers and capital is better off but land used for farming will decline.

b. Landlords will vote against the proposal as demand for land used for farming purposes will decline and thus price of land will fall. Capitalists will vote in favor of the proposal as price of capital will decline due to increase in demand of capital. Workers will also vote in favor as this will also lead to increase in the demand of labor.

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