3. Consider a world with only two countries, North and South. There are two goods: X and Y.

Assume a specific factors model. X is produced with capital (K) and labour (L) . Y is

produced with Land (T) and Labour. Labour can move freely between sectors; capital is only

useful in X and Land is only useful in Y.

Suppose that the world is initially in a free trade equilibrium. Suppose North exports X.

Now suppose that there is technological improvement in the production of X in the North.

That is, for any amount of capital and labour used in X, more output can be produced (the

marginal products of both capital and labour are higher).

a. Using a relative supply and demand diagram, illustrate what happens to the world relative

price of X (i.e. px/py). Do South's terms of trade improve or worsen?

b. What happens to the real returns to land, labour, and capital in the South? Use diagrams

to illustrate your results.

c. Suppose that everyone in the North is identical (that is, each Northerner owns one unit of

labour and an equal share of the economy's endowments of K and T). Are Northerners

better off as a result of the technological improvement? Why? [Hint: rather than

focussing on factor returns, use a production frontier diagram and think about what

happens to North's terms of trade].