Assume that Mexico has a higher labor-to-capital ratio than the United States, leaving the United States well endowed with capital relative to Mexico. Assume also that clothing is labor-intensive in production relative to autos.
a. Use the factor endowment theory framework to label the two transformation schedules below, indicating which one represents Mexico and which one the United States.
b. Assuming similar tastes or preferences as reflected in the two indifference curves shown in part a, draw the pre-trade price line for each country. Which one is steeper? What does this mean? In which country are autos relatively more expensive? Does this make sense, given what you know about production capabilities in each nation?
c. Now draw a pair of international terms-of-trade lines (one on each diagram) to illustrate the potential for trade between Mexico and the United States.
- Why must these lines be parallel to each other? Why will the new price line for the United States be steeper than the pre-trade line?
- Why will the new line for Mexico be flatter than before trade? Explain in words what this means.
- Show and explain how production will shift in each country according to comparative advantage. Drawanadditionalindifferencecurveforeachcountrytoshowthenewconsumption point.
- Identify the desired amounts of exports and imports for each country. What must be true if the terms-of- trade lines that you drew generate equilibrium in trade between Mexico and the United States?
- If you find that the United States would offer to export more autos than Mexico would like to import at the selected price ratio, would your terms-of-trade line need to become steeper or flatter to bring about equilibrium? Explain why, and what this means in terms of auto and clothing prices.
2. In the example presented in Question 1, explain what would be expected to happen to wage rates in Mexico and in the United States, according to the factor-price equalization theory. How does this help to explain labor concerns about free trade? In the real world, in what ways are the conditions for complete factor-price equalization unlikely to be met, and how might these limitations apply to the example of Mexico and the United States?
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