Answer to Question #248660 in Macroeconomics for Lorina

Question

Discuss the applicability of the Stolper-Samuelson theorem for predicting terms of trade in two countries.

Answer 1

The applicability of the Stolper-Samuelson theorem for predicting terms of trade in two countries can be explained as follows: 

Here we assume that one country is labor abundant Country 1 and the other country is capital abundant Country 2.

When the two countries trade , the price of nation's abundant and cheap factor increases and the price of it's scarce and expensive factor decreases. The real income of labor increases and the real income of owners of capital decreases in Country 1. Whereas the real income of labor decreases and real income of owners of capital increases in Country 2. It concludes the Stolper Samuelson Theorem. 

Since in the developed countries which uses the capital intensive mode of production, The trade tends to decrease the real income of labor and increase the real income of owners of capital. Therefore, labor unions in developed nations generally favor trade restriction. But this is actually not the case because loss that trade causes to labor(unskilled) is less than the gain received by owners of capital. 

So the applicability of this theorem for predicting terms of trade that is the the ratio between the index of export prices and the index of import prices depends upon the nation being capital or labor intensive and how on the basis of that their real income got affected.