ECON 3HH3 Chapter Notes - Chapter 3: Kolmogorov Space, Diminishing Returns, Relative Price

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Gains and Losses from Trade in the Specific-Factors Model
How does the changes in relative prices affect the earnings of labour, land and capital?
Two FoP: labour (L) and capital (K).
Types of models:
1. Short-run: fixed K and L
2. Mid-run: fixed K and mobile L = specific-factor model
3. Long-run: Mobile K and L
Effect of relative prices:
A. Earnings of fixed factors goes up/down the most because they’re stuck in a sector, and cannot be employed elsewhere
B. Earnings of mobile factors offsets losses from changes in relative prices by seeking employment elsewhere
Assumptions
1. Two countries: Home and foreign
2. Two sectors: manufacturing and agriculture
3. Two FoP: labour (L) and capital (K in manufacturing; T, land in agriculture)
a. Type of capital varies in sectors
4. Diminishing returns to labours: decreasing MPLM and MPLA
a. MPL is the slope of the PPF (downwards sloping)
Diminishing Returns to Labour:
- Input (LX) increases, output (QX) increases at slower rate = slope
- If you graph the slope: LX vs MPLX, the slope decreases
- Diminishing returns to labour also exist in agriculture sector
- MPL decreases since K is fixed, so less capital per worker
PPF:
- Shape: concave
Slope = MPLY / MPLX = OCX
Opportunity Cost and Price:
- Slope = OCX = Px/Py ie. relative price of X in terms of Y
MPLY / MPLX = OCX = PX/PY
- Firms will hire a person up to the point where the cost of that 1 labour = the value of the 1 labour = amount of goods
produced in that hour
W = Px*MPLX
- Assuming perfect competition, wages in both industries will be the same
- Changes in Px will shift W equilibrium and L in each market
HOME C OUNTR Y
- Diminishing returns to labour in the manufacturing and agricultural industry
Manufacturing:
- Without trade: producing and consuming at A
- With trade: producing at B and consuming at C
o Steeper slope than at no-trade
- Relative price of manufacturing, PM/PA = slope at B
- Gap of QM between B and C, supply > demand => export manufacturing
Agriculture:
- Without trade: producing and consuming at A
- With trade: producing at B and consuming at C
o Steeper slope than at no-trade
- Gap QA between B and C, demand > supply => import agriculture
FOREI GN C O UNTRY
- Assume no-trade price in foreign is higher than home, (P*M/P*A) > (PM/PA)
o Home has comparative advantage in manufacturing
Overall Gains of Trade
- With trade, the world relative price for manufacturing is higher than what it was at no-trade, so that’s more attractive to
mobile workers, so production increase from A B
- Consumption from A C means greater utility => gains of trade
- Exporting manufacturing at higher relative price and vice versa for agriculture => gains of trade
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