Suppose there are two countries Home and Foreign. They have two factors of production, labor and capital. At Home L indicates labor supply and K indicates capital stock. The respective symbol for Foreign are L* and K*. Also assume that these two countries produce only two goods: aircraft and cloth, indicated by a and c, respectively. We assume that in both countries they have the same production technology, and aircraft is capital intensive and cloth is labor intensive. Assume that K = K* and L > L*.

1) Using production possibility frontier for both countries show that at the same ratio of relative consumption of aircraft to cloth (Da/Dc) in two countries, Home will have lower (in absolute term) relative price of cloth to aircraft (Pc/Pa) before trade (you can measure labor intensive cloth on X-axis and capital-intensive aircraft on Y-axis.

2) Using PPF show that at given relative price of cloth, relative production of cloth to aircraft (Qc/Qa) will be higher at Home than in Foreign.

3) In quantity and price space, show equilibrium for two countries before trade (note that demand is assumed to be identical between two countries). What are the relative quantity produced and price charged in two countries?

4) When these two countries start trading, how is the equilibrium attained and what happens to the relative price of cloth to aircraft in two countries?

5) How does the opening of trade change production and consumption in two countries?

6) Which country exports what and what theorem you can invoke to summarize this trading pattern?

7) Using equation, show that the exports of cloth at Home is equal to the imports of aircraft time the relative price of aircraft (that is value of exports is equal to the value of imports).

8) After trade, what happens to relative price of labor to capital (w/r) and use of capital to labor at Home, and what is happening in Foreign? Explain using diagram for factor price, product price and factor use relation (use two points, one before trade and the other after trade).

9) What happens to the marginal product of both inputs at home and how does that affect factor earnings (w are r) at Home? Do you expect the opposite happening in Foreign?