Consider a country (Home) where production can be represented with a Heckscher Ohlin model. There are two goods: X and Y. And there are two inputs: unskilled labour (Lu)and skilled labour (Ls). Both inputs are fully mobile across sectors. The wage for skilled labour is Ws; the wage for unskilled labour is wu. X is relatively intensive in the use of skilled labour (compared to 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 pr.
(a) Suppose there is an increase in the supply of skilled labour.
(i) What happens to output in X and Y? Why? [Use a diagram].
(ii) What happens to the real returns to skilled 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 now that the output of X is subsidized. That is producers of X sell their output at the world price px, and also get a subsidy s for each unit of X that they sell. What happens to the real returns to skilled and unskilled labour? Use a diagram. Explain and justify your answers.