Assume two large countries, Home and Foreign, with two factors of production, capital and labor, used to produce two goods, rice and cloth. Technology is the same in two countries. Cloth production is labor intensive; Foreign is capital abundant.

a. (6 marks) Suppose Home subsidizes its exports and Foreign imposes a countervailing tariff that offsets the subsidy's effect, so that in the end, relative prices in Foreign are unchanged. What happens to the relative price of cloth, the terms of trade and the welfare of the two countries? Explain your answer.

b. (6 marks) Instead of a countervailing tariff, suppose now that Foreign instead counter by an export subsidy of its own. What happens to the terms of trade and the welfare of the two countries? Explain your answer.

Use fully labelled diagrams to support your answers.