Consider a country (Home) where production can be represented with a Specific Factors model with two goods [X and Y], three inputs [capital (K), unskilled labour (LX) and skilled labour LY)].

Capital is mobile across sectors. Unskilled labour is specific to X (i.e can only be used in X) and skilled labour is specific to Y (i.e. can only be used in Y). The economy is initially in free trade.

Assume the economy is small so that goods prices are fixed. That is, px and py are determined in world markets and nothing that this country does will affect the world prices px and py.

(a) Suppose there is an increase in the supply of skilled labour (perhaps from immigration that is restricted to skilled workers). The supply of unskilled labour stays the same. What happens to the real returns to capital, skilled labour and unskilled labour? Use a diagram. Explain and justify your answers.

(b) Consider again the original equilibrium (the supply of skilled labour did not change). Suppose instead that some capital leaves the country to be invested elsewhere. That is, the supply of capital in the country falls. What happens to the real returns to capital, skilled labour and unskilled labour? Use a diagram. Explain and justify your answers.