Hollywoodland, being self-sufficient in most products, trades only two goods with the Rest of the World (ROW), movies and automobiles. Both of these goods are produced using skilled labor (L) and capital (K) with the returns to capital being the interest rate (r) and the returns to skilled labor being the wage rate (w). The production of automobiles is capital intensive relative to the production of movies, and Hollywoodland is skilled-labor abundant relative to the ROW.a. State the Heckscher-Ohlin theorem and use it to predict the pattern of trade between Hollywoodland and the ROW.b. If the price of Hollywoodland's imports rises, while the price of its exports remain unchanged, what would happen to the factor returns in Hollywoodland in the long run? State the theorem used to explain

Question

the answer, and briefly state the intuition behind the theorem.

What will be an ideal response?

Answer 1

a. POSSIBLE RESPONSE: The Heckscher-Ohlin theorem is that a country will export the product that uses its abundant factor relatively intensively and import the product that uses its scarce factor intensively. Therefore, the Heckscher-Ohlin theorem predicts that Hollywoodland, being relatively skilled-labor abundant, will export movies, the relatively skilled-labor intensive product, and will import automobiles, the relatively capital-intensive product. 

b. POSSIBLE RESPONSE: The effects of the rising price of imports in the long-run are described by the Stolper-Samuelson theorem. The Stolper-Samuelson theorem states that, given certain conditions and assumptions-including full adjustment to a long-run equilibrium-an increase in the price of a product will raise the real return to the factor used intensively to produce that product and will decrease the real return to the factor used intensively to produce the other product. Thus, when the price of automobiles rises, in the long run, the real return to the factor used intensively (in this case capital) in the rising-price industry will increase, and the real return to the other factor (skilled labor) will fall. Here are two ways to see the intuition behind the theorem. First as the price of automobiles rises, this will bid up the returns to at least one of the factors employed in the automobile industry. It is likely to raise the interest rate because capital is used intensively in the production of cars. On the other hand, the price of movies remains unchanged, and since the price reflects the returns to capital and skilled labor, the wage must decrease. Second, an increase in the price of a good in relation to another will result in a relative expansion of this industry and a contraction of the other industry. As the demands for the two factors change, the return to the factor used intensively in the expanding industry will increase and the return to the other factor will decline.