CAFTA (Central American Free Trade Agreement) will lead to free-trade between U.

Question

CAFTA (Central American Free Trade Agreement) will lead to free-trade between U.S. and Central America. Suppose there are two factors: skilled and unskilled labor and U.S. is skilled-labor abundant. There are two goods: apparel and computers, and apparel is unskilled-labor intensive.

a. State the relevant theorem and using it explain which good each country will export when trade commences after signing of CAFTA.

b. Which factor(s) will gain in absolute terms in the U.S. in the short run? Which factor(s) will gain in absolute terms in the Central America in the short run? Explain

c. Which factor(s) will gain in the U.S. in the long run in absolute and relative terms? Which factor(s) will gain in the Central America in the long run in absolute and relative terms? Explain.

Explanation / Answer

a. Heckscher–Ohlin theorem- According to Heckscher–Ohlin theorem, US will export computer which requires use of skilled labor while Central America will export apparel which requires use of  unskilled-labor intensive.

b. In the short run, the US skilled labor will gain in absolute terms in the short run. While the Central American unskilled labor will gain absolute terms in the short run. The gain  is attributed to increase in demand for the factor inputs when the both regions specialise in their respective goods.

c. In the long term, the skilled labor will gain in the US while the unskilled labor will gain in the Central America as their wages are likely to rise vis-a-vis interest rate on capital. A result of HO theorem, the factor price equalization theorem states that the relative price of inputs among trading partners will converge without mobility of factor input.

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