Movement of Labor and Capital

5
between Countries

1. In the short-run specific-factors model, examine the impact on a small country fol-
lowing a natural disaster that decreases its population. Assume that land is specific to
agriculture, capital is specific to manufacturing, and labor is free to move between the
two sectors.
a. In a diagram similar to Figure 5-2, determine the impact of the decrease in work-
force on the output of each industry and the equilibrium wage.
Answer: The following diagram depicts a decrease in population (labor) in the
specific-factors model. The origin for agriculture shifts inward by exactly the
amount of the change in population, carrying with it the curve representing the
marginal product of labor in agriculture. (Note: one could equivalently shift the
origin and MPL curve in manufacturing and arrive at the same result. ) The new
equilibrium is determined at the intersection of PM ⴢ MPLM and (PA ⴢ MPLA )⬘,
which corresponds to a higher wage W⬘. In manufacturing, the amount of labor
decreases from OML to OML⬘ and the amount of capital remains the same. As a
result, the output of manufacturing decreases. In agriculture, the amount of labor
has decreased from OAL to OA⬘L⬘ (note that (L⬘ ⫺ L) is necessarily less than
(OA⬘ ⫺ OA ) and the amount of land remains the same. As a result, the output of
agriculture also decreases).

S-39
S-40 Solutions ■ Chapter 5 Movement of Labor and Capital between Countries

(PA · MPLA )⬘
Wage, W

⌬L
B
W1
PA · MPLA

A
W

PM · MPLM

OM L⬘ L OA⬘ OA

b. What happens to the rentals on capital and land?

Answer: Because the quantity of labor in both industries decreases due to the nat-
ural disaster, the marginal product of labor increases in both industries and the mar-
ginal products of the industry-specific factors decrease. Because it is a small coun-
try, the final output prices PA and PM remain unchanged; hence, the rental rate for
capital, PM ⴢ MPK, decreases and the rental rate for land, PA ⴢ MPT, decreases.
2. How would your answer to problem 1 change if instead we use the long-run model,
with shoes and computers produced using labor and capital?
Answer: In the long-run model, a decrease in labor does not affect factor prices at
all. Rather, the output of shoes and computers adjusts: according to the Rybczynski
theorem, the output of the labor-intensive industry (shoes) decreases and the output
of the capital-intensive industry (computers) increases. This point can be illustrated
graphically as well, as in problem 3.
3. Consider an increase in the supply of labor due to immigration, and use the long-run
model. Figure 5-8 shows the box diagram and the leftward shift of the origin for the
shoe industry. Redraw this diagram, but instead, shift to the right the origin for comput-
ers. That is, expand the labor axis by the amount ⌬L, but shift it to the right rather
than to the left. With the new diagram, show how the amount of labor and capital
in shoes and computers is determined, without any change in factor prices. Carefully
explain what has happened to the amount of labor and capital used in each industry
and to the output of each industry.
Answer: Keeping factor prices constant (i. e. , W and RK constant), the K/L ratio in
each industry remains unchanged. In the diagram below, this means that the slope of
the arrows emanating from each origin stays the same even when the total endow-
ments of capital or labor change. Shifting the origin for computers to the right ex-
pands the horizontal axis and signifies the increase in labor due to immigration.
Finding a new equilibrium involves scaling the arrows up or down from their re-
spective origins to find a unique intersection. In this case, the only possible intersec-
tion involves lengthening the shoes arrow and contracting the computers arrow. This
illustrates the Rybczynski theorem: the output of the labor-intensive industry in-
creases with additional labor in the economy (vice versa for the capital-intensive in-
dustry). The new equilibrium is identical to that in Figure 5-8, so it does not matter
to which industry the extra labor is initially added.
 Solutions ■ Chapter 5 Movement of Labor and Capital between Countries S-41

L LC OC L⬘ ⬘
OC

KC

K⬘ K⬘
B

K K
A

KS

OS LS L L⬘

4. In the short-run specific-factors model, consider a decrease in the stock of land. For
example, suppose a natural disaster decreases the quantity of arable land used for
planting crops.
a. Redraw panel (a) of Figure 5-11 starting from the initial equilibrium at point A.
Answer:
PA · MPLA
Wage, W

A PA · MPLA⬘
W

W⬘ B

PM · MPLM

OM L L⬘ OA

b. What is the effect of this change in land on the quantity of labor in each indus-
try and on the equilibrium wage?
Answer: With less land per laborer in the agriculture sector, MPLA decreases.
This is represented by an inward shift in the wage curve for agriculture and leads
to a new equilibrium at point B. In words, wages in the agriculture sector drop,
drawing labor into the manufacturing sector. The increased labor supply in the
S-42 Solutions ■ Chapter 5 Movement of Labor and Capital between Countries

manufacturing sector puts downward pressure on the wage. In the new equilib-
rium, wages are once again equalized across industries at W⬘ ⬍ W, manufactur-
ing labor increases from OML to OML⬘, and agriculture labor decreases from OAL
to OAL⬘.
c. What is the effect on the rental on land and the rental on capital?
Answer: In the manufacturing industry, the quantity of labor increases and the
amount of capital remains the same (i. e. , the labor/capital ratio increases). There-
fore, the marginal product of capital increases due to the natural disaster because
each unit of capital has more laborers working with it. As a result, the rental on
capital, PM ⴢ MPK, increases. In agriculture, the result seems ambiguous at first.
On one hand, the natural disaster decreases the stock of land, which increases the
marginal product of land. On the other hand, the movement of labor from agri-
culture to manufacturing decreases the marginal product of land. Which one of
these effects is stronger? It is possible to answer this question by looking at the
move from A to B in steps. Consider the contraction in the marginal product of
labor in agriculture from A to C: The wage is held constant by (L⬘⬘ ⫺ L)
workers leaving the agriculture industry. Because the wage has not changed, nor
has the labor/land ratio or the rental on land. Then, allowing workers to migrate
back into agriculture holding the amount of land fixed, going from C to B, the
wage is depressed to W⬘ and the marginal product of land increases. Combining
these steps, the land rental, PA ⴢ MPT, increases from A to B.
PA · MPLA
Wage, W

A PA · MPLA ⬘
W C

W⬘ B

PM · MPLM

OM L L⬘ L⬘⬘ OA

d. Now suppose that the international community wants to help the country struck
by the natural disaster and decides to do so by increasing its level of FDI. So the
rest of the world increases its investment in physical capital in the stricken coun-
try. Illustrate the effect of this policy on the equilibrium wage and rentals.
Answer: An increase in FDI increases the amount of capital in manufacturing,
shifting out the wage curve in that sector. This has the effect of raising MPLM
and hence wages, drawing additional labor into that sector. The new equilibrium
occurs at a higher wage than after the disaster. (The total effect as compared with
before the disaster will depend on the relative magnitude of the loss in land and
inflow of capital, and is therefore ambiguous. ) The agriculture sector shrinks fur-
ther due to the capital inflow, but those still employed in it enjoy a higher wage
than after the disaster. (We do not know if the wage is higher or lower than be-
fore the disaster. )
 Solutions ■ Chapter 5 Movement of Labor and Capital between Countries S-43

5. According to part A of Table 5-1, what education level loses most (that is, has the
greatest decrease in wage) from immigration to the United States? Does this result
depend on keeping the rental on capital constant? Explain why or why not.
Answer: Holding capital fixed, the table shows immigration has the greatest negative
impact on workers with very low or high levels of education and only a small nega-
tive impact on those workers with mid-level education (12–15 years). The impacts
are even smaller in the long run, when capital adjusts to keep the real return to cap-
ital fixed in each industry: in that case, workers with very low or high levels of edu-
cation lose due to immigration, but workers with mid-level education gain due to the
immigration combined with the capital adjustment. The reason that the losses are
smaller (and even become gains) in the long run is that immigration leads to capital
growth in industries.
6. Suppose that computers use 2 units of capital for each worker, so that KC ⫽ 2 ⴢ LC ,
whereas shoes use 0. 5 units of capital for each worker, so that KS ⫽ 0. 5 ⴢ LS. There
are 100 workers and 100 units of capital in the economy.
a. Solve for the amount of labor and capital used in each industry. Hint: The box
diagram shown in Figure 5-7 means that the amount of labor and capital used in
each industry must add up to the total for the economy, so that:

KC ⫹ KS ⫽ 100, and LC ⫹ LS ⫽ 100

Use the facts that KC ⫽ 2 ⴢ LC and KS ⫽ 0. 5 ⭈ LS to rewrite these equations as:

2 ⴢ LC ⫹ 0. 5 ⴢ LS ⫽ 100, and LC ⫹ LS ⫽ 100

Use these two equations to solve for LC and LS, and then calculate the amount
of capital used in each industry using KC ⫽ 2 ⴢ LC and KS ⫽ 0. 5 ⴢ LS.
Answer: The above two equations can be solved as:

2 ⴢ LC ⫹ 0. 5 ⴢ LS ⫽ 100
2 ⴢLC ⫹ 2 ⴢLS ⫽ 200

⫺1. 5 ⴢ LS ⫽ ⫺100
so that LS ⫽ 100 / 1. 5 ⫽ 66. 7. It follows from the same equations that LC ⫽
33. 3, and that KC ⫽ 2 ⴢ LC ⫽ 66. 7 and KS ⫽ 0. 5 ⴢ LS ⫽ 33. 3.
b. Suppose that the number of workers increases to 125 due to immigration, keep-
ing total capital fixed at 100. Again solve for the amount of labor and capital used
in each industry. Hint: Redo the calculations from part a, but using LC ⫹ LS ⫽
125.
Answer: The labor equations are now solved as:

2 ⴢ LC ⫹ 0. 5 ⴢ LS ⫽ 100
2 ⴢ LC ⫹ 2 ⴢ LS ⫽ 250

⫺1. 5 ⴢ LS ⫽ ⫺150
so that LS ⫽ 150 / 1. 5 ⫽ 100. It follows from the same equations that LC ⫽ 25,
and that KC ⫽ 2 ⴢ LC ⫽ 50 and KS ⫽ 0. 5 ⴢ LS ⫽ 50.
S-44 Solutions ■ Chapter 5 Movement of Labor and Capital between Countries

c. Suppose instead that the amount of capital increases to 125 due to FDI, keeping
the total number of workers fixed at 100. Again solve for the amount of labor
and capital used in each industry. Hint: Redo the calculations from part (a), us-
ing KC ⫹ KS ⫽ 125.
Answer: The first labor equation is now 2 ⴢ LC ⫹ 0. 5 ⴢ LS ⫽ 125, so the labor
equations are solved as:

2 ⴢ LC ⫹ 0. 5 ⴢ LS ⫽ 125
2 ⴢ LC ⫹ 2 ⴢ LS ⫽ 200

⫺1. 5 ⴢ LS ⫽ ⫺75
so that LS ⫽ 75 / 1. 5 ⫽ 50. It follows from the same equations that LC ⫽ 50,
and that KC ⫽ 2 ⴢ LC ⫽ 100 and KS ⫽ 0. 5 ⴢ LS ⫽ 25.
d. Explain how your results in parts (b) and (c) are related to the Rybczynski the-
orem.
Answer: Comparing part (a) with part (b), the increase in the amount of labor
in the economy has increased the amount of labor and capital devoted to shoes
(from LS ⫽ 66. 7 and KS ⫽ 33. 3 to LS ⫽ 100 and KS ⫽ 50) and decreased the
amount of labor and capital devoted to computers (from LC ⫽ 33. 3 and KC ⫽
66. 7 to LC ⫽ 25 and KC ⫽ 50). Therefore, the output of shoes increases and the
output of computers decreases, due to the overall increase in labor. Shoes are la-
bor-intensive because they use 0. 5 units of capital per unit of labor, computers
are capital-intensive because they use 2 units of capital per unit of labor. So the
change in outputs is in accordance with the Rybczynski theorem: the increase in
labor has increased the output of the labor-intensive good and decreased the out-
put of the other good.
Conversely, comparing part (b) with part (d), there has been an increase in the
amount of capital in the economy. Consistent with the Rybczynski theorem,
there has been a rise in the amount of labor and capital devoted to computer pro-
duction (from LC ⫽ 33. 3 and KC ⫽ 66. 7 to LC ⫽ 50 and KC ⫽ 100) and a fall
in the amount of labor and capital devoted to shoe production (from
LS ⫽ 66. 7 and KS ⫽ 33. 3 to LS ⫽ 50 and KS ⫽ 25).
The following two questions explore the implications of the Rybczynski theorem and the
Factor Price Insensitivity result for the Heckscher-Ohlin model, from Chapter 4.
7. In this question we use the Rybczynski theorem to review the derivation of the
Heckscher-Ohlin theorem.
a. Start at the no-trade equilibrium point A on the Home PPF in Figure 4-2, panel
(a). Suppose that through immigration, the amount of labor in Home grows.
Draw the new PPF and label the point B where production would occur with
the same prices for goods. Hint: You can refer back to Figure 5-9 to see the ef-
fect of immigration on the PPF.
Answer: Figure 5-9, reproduced below, shows the shift in the Home PPF due to
the inflow of labor. With the same prices for goods, production occurs at point
B, with greater output of shoes and less output of computers, in accordance with
the Rybczynski theorem.
 Solutions ■ Chapter 5 Movement of Labor and Capital between Countries S-45

Output of
shoes, QS

A*

Output of
computers, QC

b. Suppose that the only difference between Foreign and Home is that Foreign has
more labor. Otherwise, the technologies used to produce each good are the same
across countries. Then how does the Foreign PPF compare with the original
Home PPF (without immigration) that you drew in part (a)? Is point B the no-
trade equilibrium in Foreign? Explain why or why not.
Answer: The Foreign PPF is shifted out and upward as compared with the orig-
inal Home PPF, just like immigration shifted out the Home PPF. This result fol-
lows because the only difference between Home and Foreign is that Foreign has
more labor (but has the same technologies for producing the two goods as at
Home). Therefore, the Foreign PPF is shifted out as compared with the original
Home PPF, and is, in fact, identical to the Home PPF inclusive of the immigra-
tion inflow. Assuming that point A is the no-trade equilibrium at Home, and
that the two countries have the same tastes, then point B cannot be the no-trade
equilibrium in Foreign. The reason for this is that because an indifference curve
is tangent to the Home no-trade equilibrium at point A, then an indifference
cannot also be tangent to point B.
c. Illustrate a new point, A *, that is the no-trade equilibrium in Foreign. How do
the relative no-trade prices of computers compare in Home and Foreign? There-
fore, what will be the pattern of trade between the countries, and why?
Answer: The Foreign no-trade point A * is shown with an indifference curve tan-
gent to it. The slope of the Foreign indifference curve at A* exceeds the slope of
the Home indifference curve at A. Because the slopes of the indifference curves
at the relative price of computers (the good on the horizontal axis), this proves that
the no-trade relative price of computers in Foreign exceeds the no-trade relative
price of computers at Home. With trade, Home will export computers (to obtain
the higher relative price in Foreign), and Foreign will export shoes (to obtain the
higher relative price at Home). Because Foreign is labor-abundant, this trade pat-
tern is in accordance with the Heckscher-Ohlin theorem.
Note: This question has redone the proof of the Heckscher-Ohlin theorem from the begin-
ning of Chapter 4. Because we now have used the Rybczynski theorem in part (a), the
comparison of the Home and Foreign PPFs is more precise than we achieved at the be-
ginning of Chapter 4 (where we relied on an intuitive comparison of the two countries’
PPFs).
S-46 Solutions ■ Chapter 5 Movement of Labor and Capital between Countries

8. Continuing from problem 7, we now use the Factor Price Insensitivity result to com-
pare factor prices across countries in the Heckscher-Ohlin model.
a. Illustrate the international trade equilibrium on the Home and Foreign produc-
tion possibility frontiers. Hint: You can refer back to Figure 4-3 to see the inter-
national trade equilibrium.
Answer: The international trade equilibrium is as shown in Figures 4-3 and
4-4, with Home exporting computers and Foreign exporting shoes. Both coun-
tries face the same world relative price of computers (or shoes).
b. Suppose that the only difference between Foreign and Home is that Foreign has
more labor. Otherwise, the technologies used to produce each good are the same
across the countries. Then according to the Factor Price Insensitivity result, how
will the wage and rental compare in the two countries?
Answer: This is just like problem 7, where Foreign has more labor than Home
but is otherwise identical. In particular, they face the same world relative price.
So according to the Factor Price Insensitivity result, the inflow of labor (into
Foreign) has no effect on the wage or rental (as compared with those earned at
Home). In other words, the wage and rental in the two countries are the same!
This result is called the “factor price equalization” theorem and applies to coun-
tries trading in the Heckscher-Ohlin model, where technologies are the same
across countries.
c. Call the result in part (b) “factor price equalization. ” Is this a realistic result?
Hint: You can refer back to Figure 4-9 to see wages across countries.
Answer: The “factor price equalization” theorem is a logical result in the
Heckscher-Ohlin model, but it is not a very realistic result. In Figure 4-11 we
showed that wage differs a great deal across countries, whereas the “factor price
equalization” theorem would predict that wages are the same.
d. Based on our extension of the Heckscher-Ohlin model at the end of Chapter 4,
what is one reason why the “factor price equalization” result does not hold in
reality?
Answer: The reason that the “factor price equalization” theorem does not hold
in practice is that technologies differ quite a bit across countries, as we discussed
at the end of Chapter 4. Just like we need to take into account the differences
in technologies to obtain more realistic predictions about trade from the
Heckscher-Ohlin model, so too we need to recognize that the differences in
technologies will mean that factor prices differ across countries, even when they
are engaged in free trade and the relative prices of goods are the same.
R PK
9. Recall the formula ᎏᎏ ⫽ ᎏᎏ(i ⫹ d) from the application, “The Effect of FDI on
P P
Rentals and Wages in Singapore. ” Give an intuitive explanation for this formula for
the rental rate. Hint: Describe one side of the equation as a marginal benefit and the
other as a marginal cost.
Answer: The equation above is one way to calculate the real returns to (rental of )
capital, R/P. An intuitive way to think about this is to imagine that you are the owner
of a unit of capital and you are considering whether to rent it out at the prevailing
nominal rental rate, R, or to sell it and invest the proceeds. On one hand, you could
sell each unit of capital for a price of PK and receive interest income on the proceeds
of PKi. On the other hand, you could rent out the capital for a nominal payment of
R and incur the direct depreciation cost of the asset of PKd. Thus, the nominal pay-
ment you would require (R, the marginal benefit of rental) to make you indifferent
between the two options would be PKi ⫹ PKd, the sum of direct costs of renting out
and the opportunity cost of a sale (together, the marginal cost of rental). Dividing
 Solutions ■ Chapter 5 Movement of Labor and Capital between Countries S-47

both sides by the price level, P, puts the equation into real terms and yields the de-
sired equation.
10. In Table 5-2, we show the growth in the real rental and real wages in Singapore, along
with the implied productivity growth. One way to calculate the productivity growth
is to take the average of the growth in the real rental and real wage. The idea is that
firms can afford to pay labor and capital more if there is productivity growth, so in
that case, real factor prices should be growing. But if there is no productivity growth,
the average of the growth in the real rental and real wage should be close to zero.
To calculate the average of the growth in the real factor prices, we use the shares of
GDP going to capital and labor. Specifically, we multiply the growth in the real rental
by the capital share of GDP, and add the growth in the real wage multiplied by the
labor share of GDP. Then answer:
a. For a capital-rich country like Singapore, the share of capital in GDP is about
one half and the share of labor is also one half. Using these shares, calculate the
average of the growth in the real rental and real wage shown in each row of Table
5-2. How do your answers compare with the productivity growth shown in the
last column of Table 5-2?
Answer: As shown in column (3) of the table, when using a capital share of 0. 5,
as applies for a country like Singapore, the implied productivity growth is close
to that in Table 5-2, shown in column (5).

(3) (4)
Productivity Productivity (5)
Using Capital Using Capital Productivity
(1) (2) Share of 0.5 ⫽ Share of 0.33 ⫽ from
Rental Wages (1) ⴢ 0.5 ⫹ (2) ⴢ 0.5 (1) ⴢ 0.33 ⫹ (2) ⴢ 0.67 Table 5-2

⫺5.0 2.6 ⫺1.2 0.1 ⫺1.5

⫺1.9 0.5 ⫺0.7 ⫺0.3 ⫺0.7
⫺3.4 1.6 ⫺0.9 ⫺0.1 ⫺1.1

1.6 2.7 2.2 2.3 2.2

⫺0.2 3.2 1.5 2.1 1.5
⫺0.5 3.6 1.6 2.2 1.6

b. For an industrialized country like the United States, the share of capital in GDP
is about one third, and the share of labor in GDP is about two thirds. Using these
shares, calculate the average of the growth in the real rental and real wage shown
in each row of Table 5-2. How do your answers now compare with the pro-
ductivity growth shown in the last column?
Answer: As shown in column (4) of the table, when using a capital share of 0. 33,
as applies for a country like the United States, the implied productivity growth
is not as close to that in Table 5-2, shown in column (5).
11. Figure 5-14 is a supply-and-demand diagram for the world labor market. Starting at
points A and A *, consider a situation where some Foreign workers migrate to Home,
but not enough to reach the equilibrium with full migration (point B). As a result of
the migration, the Home wage decreases from W to W⬙ ⬎ W⬘, and the Foreign wage
increases from W * to W ** ⬍ W⬘.
a. Are there gains that accrue to the Home country? If so, redraw the graph and
identify the magnitude of the gains for each country. If not, say why not.
Answer: Gains from trade in the following graph are analogous to consumer and
producer surplus in the conventional supply and demand setting. In this case,
Home employers are willing to pay up to W for the marginal product of labor
S-48 Solutions ■ Chapter 5 Movement of Labor and Capital between Countries

that they obtain for W⬙; thus the gains to the Home country are illustrated by the
horizontally striped triangle. Similarly, the immigrating Foreign workers are
willing to supply their marginal product for a lower wage in the Foreign coun-
try (W *) but receive a higher wage in the Home country (W **).
Wage, W Foreign
wage

A
W
W ⬘⬘
W⬘

W **
W*

A* Home
wage

O L L⬘ O*

L L*

b. Are there gains that accrue to the Foreign country? If so, again show the magni-
tude of these gains in the diagram and show the world gains.
Answer: Gains to Foreign (including foreign emigrants) are represented by the
vertically striped triangle. Given positive gains to both countries, total gains from
immigration are also positive in this model.
12. A housekeeper from the Philippines is contemplating immigrating to Singapore in
search of higher wages. Suppose that the housekeeper earns approximately $2,000
annually and expects to find a job in Singapore worth approximately $5,000 annu-
ally for a period of 3 years. Furthermore, assume that the cost of living in Singapore
is $500 more per year than at home.
a. What can we say about the productivity of housekeepers in Singapore versus the
Philippines? Explain.
Answer: Assuming that housekeeping is a perfectly competitive industry, house-
keepers’ wages are equal to their marginal product of labor. Because wages are
higher in Singapore, housekeepers there are more productive.
b. What is the total gain to the housekeeper from migrating?
Answer: The total gains from migrating are the net benefits relative to staying in
the Philippines—that is, salary of $5,000 minus the opportunity cost of working
in the Philippines of $2,000, minus the extra costs of living in Singapore of $500.
Annual gains from migrating (over the first 3 years) are $2,500.
c. Is there a corresponding gain for the employer in Singapore? Explain.
Answer: The gains to the employer in Singapore depend on whether the wage
is driven down by the migration, as shown in problem 11.