Reference no: EM132200800

Question: Suppose that a developing country is a small-open economy in a world with two factors: skilled and unskilled labor. The country produces two goods: Agricultural goods, which are relatively intensive in unskilled labor, and software, which is relatively intensive in skilled labor. Assume that technologies and tastes are identical across countries. Suppose that this developing country has a skilled-to-unskilled labor ratio that is lower than in the rest of the world (RW).

Now suppose that the developing country pays back a large loan to the RW (income transfer) and that the marginal propensity to consume agricultural goods is higher in the developing country than in the RW (in other words, from now on, tastes are not identical anymore across countries):

1. Use a graph with the developing country's PPF to answer the following questions: What effect will the income transfer have on the production point in the developing country? What effect will it have on the gains from trade in the developing country?

2. What would be the effect on the skill premium in the developing country of this income transfer to the RW? (the skill premium is defined as the skilled wage divided by the unskilled wage)