Suppose the Home country produces bicycles using capital (K) and labor (L) and n

Question

Suppose the Home country produces bicycles using capital (K) and labor (L) and natural gas using land (T) and labor (L). Labor is mobile across sectors, while capital and land are fixed in their respective industries. When Home trades with the only other country in the world, Foreign, Home imports natural gas and exports bicycles. Now, suppose the size of the Home country is reduced by 50 percent. That is, the amount of land, labor and capital available for production are all reduced by 50 percent, reducing the potential output of each sector by 50 percent.

a. Is the reduction in the Home country’s size likely to change the pattern of trade? Explain.

b. Might the reduction in the Home country’s size change the relative price of bicycles under trade? Explain.

c. Show the movement along the PPF that will occur in the Home country as a result of the change in size.   How has output changed? Explain.

d. Suppose that I, an owner of capital, live in the Home country. Am I made better or worse off by the reduction in the Home country’s size?

Explanation / Answer

a. As the size of the home country will reduce by 50 percent and resources will reduce by 50 then production of bicycle will also reduce by 50 percent. It will happen because the endowment of resources to produce the bicycle will reduce by 50 percent. This has impact on trade relative price of bicycle in terms gas will increase. So as relative price of bicycle increases the pattern of trade will remain same but benefit and volume of trade will change. It will affect the opportunity cost of production.

b. Yes, the reduction in home country's size will affect the relative price of bicycle. Due to reduction in size of home country there will reduce the production of home country. Due to decrease in production there will increase the relative price of bicycle.

c. In PPF draw intially there will be higher production of bicycle and a certain level of gas. In second point reduce the bicycle production by 50 percent keeping other fixed.

d. If I am an owner of capital of capital I will be worse of due to this reduction. I will have less amount of capital to give or for use. So less amount interest I shall get as a return. Though the price of capital may increase but overall I shall loose because of less amount of capital in hand.

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