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Question

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Agriculture products (A) are produced with land and labor, and manufacturing products (M) are produced using capital and labor. Labor is perfectly mobile between industries but cannot move internationally. Suppose there are two countries. Home and Foreign, that are identical except that Home has a larger endowment of labor than Foreign. The two countries are engaged in free trade. Given this scenario, is there any motive for capital to move internationally? If so, which direction would it move?

Explanation / Answer

In this problem, two products aremaufactured. They are 1. agricultural product and 2. Maufacturing product. Agricultural product is manufactured by usinh land and labor. Maufacturing product will require capital and labor. So labor is required in both products.

Now labor can freely move from one product to another. But it cannot move outside the countrys domain. There is another country. Question is whether capital will move to foreign country or not. It will depend upon marginal productivity of capital. It is the extra unit produced from one extra unit of capital. Suppose in domestic economy, one extra unit can produce 2 units of maufactured product. Then marginal productivity of capital within home country is 2. Now suppose same capital in foreign country can produce 3 unitsof output. So marginal productivity is better here. In this situation, there will be a tendency of capital to move from domestic country to foreign country.

Due to such outflow, capital will be scarce. This scarcity will be fulfilled to some extent by substituting labor for capital. This labor will flow from agricultural sector to maufacturing sector, since marginal productivity of labor has increased in maufacturing sector due to scarcity of capital.

However, labor cannot be a perfect substitute of capital. As a result, marginal productivity of capital will rise in domestic market as it becomes more and more scarce. Ultimately a situation will come when marginal productivity of capital in domestic market will be at per with the marginal productivity of capital in foreign market. Then outflow of capital will stop.

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