Consider a model of the Hecksher-Ohlin variety. A small, open economy produces two goods, bicycles and blue-jeans, using only two inputs, labour and capital, under constant returns to scale. Bicycles are capital intensive and blue-jeans are labour intensive. In the short run, the available amounts of capital and labour are fixed for the economy as a whole, but both factors are free to move across sectors.

1) First consider this economy in autarky. Show diagrammatically, and explain in words, how output of bicycles and blue-jeans is determined. Provide intuition.

2) Also in autarky, show diagrammatically, and explain in words, how equilibrium in the factor markets is determined. In particular, show what the equilibrium factor price ratio is. Provide intuition.

3) Now, still in autarky, suppose that suddenly the overall capital stock in the economy goes up (perhaps as the result of the donation of a large number of machine tools, usable for the production of both bicycles and blue-jeans, from abroad). What happens to the factor price ratio? To the total wage bill? To the functional distribution of income between capital and labour?

4) Now assume that all obstacles to international trade are suddenly eliminated, and that as a result of the opening up of the economy, the relative price of blue-jeans goes up. Show diagrammatically, and explain in words, how the new output of bicycles and blue-jeans is determined. Provide intuition.

5) Show diagrammatically, and explain in words, how the new equilibrium in the factor markets is determined. In particular, show what the new equilibrium factor price ratio is. Provide intuition.

6) What happens to the functional distribution of income between capital and labour as a result of the trade liberalization? Do workers in the home economy win or lose? Provide detailed intuition. What does this say about the relationship between free trade and income equality more generally?