Consider a standard Heckscher-Ohlin model of trade between the United States and the European Union, in which the only resources are capital (K) and labor (L), and the only goods are chemicals (C) and electronics (E), both produced under perfect competition, with constant returns to scale, diminishing marginal returns, identical technologies, and identical preferences, and no transportation costs. The US is relatively capital abundant, and chemical production is relatively capital-intensive.
- Use an Edgeworth allocation box, with chemical production in the southwest origin and labor on the horizontal axis, to show that unless the isoquants are tangent and explain what this means in economic terms that any allocation is not Pareto optimal.
- In the Edgeworth allocation box, show how the movement from autarky to free trade affects the allocation of capital and labor in the long run between sectors, and how this affects both the wage-rental rate and the capital-labor ratios in each sector.
- In the above Edgeworth allocation box, show that if labor moves is mobile but capital is not then the resulting allocation is not Pareto Optimal in the long run.
Use an Edgeworth distribution box, with the United States’ PPF in the southwest origin and the quantity of chemicals on the horizontal axis, to show how Pareto optimal distributions require that relative marginal costs equal relative prices equal relative marginal utilities, not just within a country but across countries.