[25 marks] Consider a world with only two countries, North and South. There

are two goods: X and Y. Assume a specific factors model. X is produced with

capital (K) and labour (L) . Y is produced with Land (T) and Labour. Labour can

move freely between sectors; capital is only useful in X and Land is only useful in

Y.

Suppose that the world is initially in a free trade equilibrium. Suppose North

exports X. Now suppose that there is neutral technological improvement in the

production of X in the North. That is, let the production technology in the X

sector be X = lF(K,L) and suppose that l rises.

a. Using a relative supply and demand diagram, illustrate what happens to the

world relative price of X (i.e. px/py). Do South's terms of trade improve or

worsen?

b. What happens to the real returns to land, labour, and capital in the South?

Use diagrams to illustrate your results.

c. Suppose that everyone in the North is identical (that is, each Northerner

owns one unit of labour and an equal share of the economy's endowments of

K and T). Are Northerners better off as a result of the technological

improvement? Why? [Hint: rather than focussing on factor returns, use a

production frontier diagram and think about what happens to North's terms

of trade].