1. Heckscher-Ohlin Model: Suppose that a free-trade equilibrium exists in a two-country, two-good, two-factor world. Assume that the two goods, chemicals (C) and electronic appliances (E), both employ capital (K) and labor (L), and that both factors are perfectly mobile across sectors. Also assume that:

• The US is relatively capital-abundant

• Mexico is relatively labor-abundant.

• Chemicals are relatively capital-intensive.

• Electronic appliances are relatively labor-intensive.

• Assume that tastes and technologies are identical in the two countries.

(a) On the graph below, sketch the relationship between relative product price, relative factor price and relative factor use in each industry in the US and Mexico. (Under the assumption of identical technologies, the same curves can be used to describe the relationships in both the US and Mexico.)

(b) On the graph below, sketch & label the relative supply curves of the two countries.

• Briefly explain why they differ:

• Then, sketch & label the world relative supply curve.

(c) Using the graph in part (a), label the relative price of electronics, the relative wage (w/r), and each industry's relative employment of labor-to- capital in each country prior to trade (i.e. in autarky). Then make the following comparisons (write >, <, or =):

(P_E/P_C)^US -----(P_E/P_C)^Mexico

(w/r)^US-----(w/r)^Mexico

(LE/KE)^US-----(LE/KE^)Mexico

(LC/KC)^US ----- (LC/KC)^Mexico

(d) Before trading, is the real wage higher in the US or Mexico? Briefly explain why.

(e) Now suppose that the US and Mexico trade freely. Which good will Mexico export to US?

(f) Describe the effect of free trade on:

• The relative price of electronics (P_E/P_C) in the US.: increases/decreases

• The relative wage (w/r) in the US: increases/decreases
Briefly explain why:

• The real wage in the US: increases/decreases
Briefly explain why:

• The real wage in Mexico: increases/decreases
Briefly explain why:

(g) Of the four groups below, who are the "winners" and who are the "losers" from the freeing of trade between the US and Mexico?

• Capital owners in the US: winners/losers
• Capital owners in Mexico: winners/losers
• Workers in the US: winners/losers
• Workers in Mexico: winners/losers

(h) Suppose the PPF for the US is given by the graph below. Using this graph, demonstrate that in theory, all individuals in the US could be made better off by trading freely with Mexico.
• Briefly describe what sort of policy would be necessary in practice to make every individual better off.

(i) TRUE/ FALSE (Explain your answer briefly): Under free trade, an expansion of Mexico's capital endowment leads to a reduction in US's overall welfare.

(j) TRUE/ FALSE (Explain your answer briefly): After Mexico's capital endowment increases, US would now be better off if it did not trade with Mexico.

2. Heckscher-Ohlin Model: The graph below shows the production possibilities frontier of a country that produces two goods: semi-conductors (S) (skill-intensive) and furniture (F) (unskilled labor-intensive). Assume that this country engages in free trade, and that it has a relatively high ratio of skilled labor to unskilled labor compared to the rest of the world (i.e. this country is skill-abundant).

(a) Which good will this country export to the rest of the world?

Consider the effect of an increase in the population of unskilled labor in this country.

In particular:

(b) Using the graph on the left, show the effect on the country's production possibilities frontier (sketch the new PPF).

(c) Using the graph on the right, show what happens to the world relative supply of furniture.

(d) What happens to the country's terms of trade and to its overall welfare?

3. TRUE/ FALSE (Explain your answer briefly): In the Heckscher-Ohlin Model with two countries and two goods, a country that produces both goods in the free trade equilibrium neither gains nor loses from trade.

4. TRUE/ FALSE (Explain your answer briefly): The predictions of the Heckscher- Ohlin Model are consistent with the fact that wage inequality, as measured by the ratio of skilled to unskilled wages, increased in both the US (a skill-abundant country) and in Mexico (abundant in unskilled labor) as trade between the US and Mexico was liberalized.