problem 1 A good is produced using three production activities (a, b, and c) tha

Question

problem 1 A good is produced using three production activities (a, b, and c) that each use skilled and unskilled labor. The table below shows the number of skilled and unskilled workers needed to produce one unit in each production stage. There are two countries Home (H) and Foreign (F). The skilled worker wage is $4 in H and $5 in F. The unskilled worker wage is $2 in II and $1 in F. Transport costs of $2 per unit must be added to cost of a production stage if that production stage is outsourced to F. Given this information, which production activities are done in which countries? If the transport cost falls to zero, what happens to the location of production of each stage (assume that the wages don't change). Calculate and compare the skill/unskill ratio of production in the two countries before and after the fall in transport costs. What has happened to relative demand for skilled labor in each country?

Explanation / Answer

1. Given the statistics,

At home,

Skilled worker wage = $4

Unskilled worker wage = $2

Cost of production in production activity A = 1*4 + 4*2 = $12

Cost of production in production activity B = 2*4 + 3*2 = $14

Cost of production in production activity C = 3*4 + 2*2 = $16

In Foreign,

Skilled worker wage = $5

Unskilled worker wage = $1

Cost of production in production activity A = 1*5+ 4*1 = $9

Cost of production in production activity B = 2*5 + 3*1 = $13

Cost of production in production activity C = 3*5 + 2*1 = $17

1a. Given the fact that a transportation cost of $2 per unit must be added to the cost of a production stage if a production stage is outsourced, it can be seen that production stage 1 will be at 11$ (9 + 2) if it is outsourced in F. This cost is lower than 12$ at H. Production activity B and C will be done in both the countries because the transportation cost raises the total cost and eliminates the cost advantage.

1b. Assuming that wages don't change, if the transportation cost falls to zero then production will occur in that location which has a cost advantage in the production of that stage. With this, Production activity A and B will be outsourced to F by H because production cost is lesser in F. Production activity C will be outsourced by F to H.

1c. Before the fall in transportation cost, at H the skill/unskill ratio of production was:

Skill 2+3 Unskill 3+2

Skill 5 Unskill 5

ratio 1:1

After the transportation cost fell to zero, this ratio became,

Skill 3 Unskill 2

ratio 3:2

Similarly, before the fall in transportation cost, at F the skill/unskill ratio of production was:

Skill 1+2+3 Unskill 4+3+2

Skill 6 Unskill 9

ratio 2:3

After the transportation cost fell to zero, this ratio became,

Skill 1+2 Unskill 4+3

Skill 3 Unskill 7

ratio 3:7

These ratios imply that the relative demand for skilled labour at Home is 3/5 (earlier it was 1/2) while in Foreign it is 3/10 (earlier it was 2/5), which means that the relative demand for skilled labour in foreign has fallen while at home it has risen.

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