Suppose there are two countries in the world, Canmerica and Chinam, that initial

Question

Suppose there are two countries in the world, Canmerica and Chinam, that initially have no economic interaction. The wage rate in Canmerica is $20 per hour and the annual rate of return on capital investment is 10%. The wage rate in Chinam is $5 per hour and the annual rate of return on capital investment is 25%.

a) If workers have equal skills in both countries, what might account for the differences between returns to labor and capital in the two countries?

b) If the two countries decide to drop barriers to labor movement and labor movement is costless, what will happen to labor and capital compensation in these two countries (account for wins and who loses and the net gain or loss to open migration)?

c) If the countries maintain barriers to migration but allow for free movement of capital and goods, how will your answer to (b) change (assume movement of capital and goods is also free).

Explanation / Answer

a) The trade interactions between countries are based on comaparative advantage that these countries have .The relative economic prices decide the labor wages in respective countries and resource abundance . If the prices are higher in canmerica than chinam , workers shall get higher pay than the other . Similarly countries financial market decided returns on capital investment which is different from one another .

b)When trade opens up the workers will be willing to migrate to better paying countries , high amount of labour moves to canmerica to get wages $20 and chinam loses on its labour market supply .Whereas there will be capital flight from canmerica to chinam to earn 25% rate of return on capital investments . Therefore capital flight will not be beneficial when the international trade opens up

c)If the country opens up only for trade of goods and services then Chinam will get to export more because they have relatively cheaper prices .This helps to improve their export balance and earns BOP surplus . But with shift of capital flight the Canmerica loses large capital investment for having lower rate of returns

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