Germany produces agricultural and manufactured products. When Germany engages in free trade, it starts exporting manufactured products. What are the predictions of the HO model on changes in real rental?Group of answer choicesNone of the other three optionsReal rental rates decrease in manufacturing sector and increase in agricultural sectorReal rental rates increase in manufacturing sector and decrease in agricultural sectorRental rates are not affected by the transition to free trade
Question
Germany produces agricultural and manufactured products. When Germany engages in free trade, it starts exporting manufactured products. What are the predictions of the HO model on changes in real rental?Group of answer choicesNone of the other three optionsReal rental rates decrease in manufacturing sector and increase in agricultural sectorReal rental rates increase in manufacturing sector and decrease in agricultural sectorRental rates are not affected by the transition to free trade
Solution
The correct answer is "Real rental rates increase in manufacturing sector and decrease in agricultural sector". Here's why:
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The Heckscher-Ohlin (HO) model predicts that a country will export goods that use its abundant factors intensively, and import goods that use its scarce factors intensively. In this case, Germany starts exporting manufactured products when it engages in free trade, suggesting that it has an abundance of the factors used intensively in manufacturing.
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According to the HO model, the return to the abundant factor (in this case, the factors used in manufacturing) will increase when a country moves to free trade. This is because the demand for this factor increases as the country produces more of the good that uses this factor intensively (manufactured products) for export.
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Conversely, the return to the scarce factor (in this case, the factors used in agriculture) will decrease. This is because the country will be producing less of the good that uses this factor intensively (agricultural products), as it is now importing this good.
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Therefore, we can expect real rental rates to increase in the manufacturing sector (as this sector expands due to increased exports) and decrease in the agricultural sector (as this sector contracts due to increased imports).
The other options are not consistent with the predictions of the HO model. The model does predict changes in factor returns when a country moves to free trade, so the option that rental rates are not affected is incorrect. The option that real rental rates decrease in the manufacturing sector and increase in the agricultural sector is also incorrect, as it is the opposite of what the HO model predicts.
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