Reference no: EM132402589

Two large countries, the US and China, produce only two goods, manufactured goods and financial services, using two factors of production, skilled and unskilled labour. The production of financial services is relatively skilled-labour intensive and manufacturing is unskilled-labour intensive. The US is relatively well-endowed with skilled labour, whereas China is relatively well endowed with unskilled labour. Assume that each society's preferences over the two goods are identical.

(a) Draw the production possibilities frontier (PPF) for the US. Carefully explain the shape of the PPF. How will the PPF of China differ?

(b) Suppose there is no trade between the two countries. Explain why, in a competitive equilibrium, the relative price of financial services must be lower in the US than in China.

(c) Explain why the neoclassical (Heckscher-Ohlin) theory of trade implies there must be an increase in the goods available for consumption in both countries as a result of opening to free trade. Does this imply that all households in each economy will gain from trade? Explain.

(d) Provide an economic argument to justify a protectionist policy in China that imposes a tariff on financial services from the US. What problems may arise in following such a strategy in the long run?