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].

4.

Suppose that East is completely identical to South (it has the same supply of K,L and T and

same technology. So East's RS curve is the same as South's. Suppose now that there is a free

trade agreement between North, South and East.

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

relative price of M (i.e. pM

W / pA

W ).

b. What happens to the terms of trade in North and South? Why? Does the free trade

agreement increase overall consumption possibilities in North? What about South? Use

the production frontiers and budget constraints to answer this.

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

illustrate your results. Who in the South would support the free trade agreement?