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# ECON

319 Assignment 1
Suggested Solutions

Question 1

Compute world trade flows in this example. Country A has an income of \$6 trillion and spends 40
percent of that income on country Bs production. Thus, exports from country B to country A are
equal to \$6 trillion 40% = \$2.4 trillion. Country B has an income of \$4 trillion and spends 60
percent of this on country As production. Thus, exports from country A to country B are equal
to \$4 trillion 60% = \$2.4 trillion. Total world trade in this simple model is \$2.4 + \$2.4 = \$4.8
trillion. What happens if we double GDP in both countries? Now GDP in country A is \$12 trillion,
and GDP in country B is \$8 trillion. However, the share of world income (and spending) in each
country has not changed. Thus, country A will still spend 40 percent of its income on country B
products, and country B will still spend 60 percent of its income on country A products. Exports
from country B to country A are equal to \$12 trillion 40% = \$4.8 trillion. Exports from country
A to country B are \$8 trillion 60% = \$4.8 trillion. Total trade is now equal to \$4.8 + \$4.8 = \$9.6
trillion. Looking at trade before and after the doubling of GDP, we see that total trade actually

Question 2

a. Germany has an absolute advantage in both cheese and cars.
b. 1 cheese = 0.25 car in France; 1 cheese =1 car in Germany
c. same as Part (b).
d. France has a comparative advantage in cheese because its opportunity cost in terms of
cars is lower (0.25 car vs. 1 car); Germany has a comparative advantage in car production
e. The trade price of cheese will settle between 0.25 car and 1 car.

At this price there would be no gains from trade for France.

Question 3
This is not a contradiction. The gains from trade imply that the winners could compensate the
losers completely and still have gains left over. Some people may lose jobs but others benefit
from the higher demand for their product. As long as the winners gains are greater than the
losers losses, we can conclude that the nation wins.

Question 4
The error in the logic is the failure to take into account the differences in productivity. The low-
wage workers in less developed countries in general are paid less because they produce less
output during each hour of labour. Furthermore, the developed nations and the less-developed
nations are not in competition for economic growth. Growth in one country benefits the other
through an increase in the demand for its products. Economic nationalists tend to view trade as
a zero-sum game in which one side loses and the other wins.

Question 5

ii) The United Kingdom gains 4C.

iii) 3C < 4W < 8C.

iv) Canada would gain 3C while the United Kingdom would gain 2C.
b) i.) The cost in terms of labour content of producing wheat is 1/4 in Canada and 1 in the United
Kingdom, while the cost in terms of labour content of producing cloth is 1/3 in Canada and 1/2
in the United Kingdom.

ii) In Canada, Pw=\$1.50 and Pc=\$2.00.

iii) In the United Kingdom, Pw=1.00 and Pc=0.50.

Question 6
a) See Figure 1 below.

b) In Canada Pw/Pc=3/4, while in the United Kingdom, Pw/Pc=2.

c) In Canada Pc/Pw=4/3, while in the United Kingdom Pc/Pw=1/2.

Question 7
See figure 2 below. The autarky points are A and A' in Canada and the United Kingdom, respectively.
The points of production with trade are B and B' in Canada and the United Kingdom, respectively.
The points of consumption are E and E' in Canada and the United Kingdom, respectively. The gains
from trade are shown by E > A for Canada and E' > A' for the U.K.

Question 8
products, then the entire economy gains from the resulting increase in consumption. In addition,
labour previously utilized in the dairy industry is made available to be hired in sectors in which
Canada is more efficient at production.

Question 9
a. Labour is the variable factor and capital and land are specific.
b. Canada is land abundant relative to the United States (100/10 is greater than 100/50), so
land. The United States comparative advantage is steel.
c. In the United States, owners of land are hurt by trade, owners of capital benefit, and the effects
on labour are indeterminate. The latter effect depends on labours preference for bread and
steel. In the United States, bread prices fall, but steel prices rise. In Canada, owners of land
benefit from trade, owners of capital are hurt, and the effects on labour are indeterminate. The
steel prices fall.

Question 10
a. The production possibility curve is a straight line that intercepts the apple axis at 400 (1,200/3)
and the banana axis at 600 (1,200/2).

b. The opportunity cost of apples in terms of bananas is 3/2. It takes 3 units of labour to harvest
an apple but only 2 units of labour to harvest a banana. If one forgoes harvesting an apple, this
frees up 3 units of labour. These 3 units of labour could then be used to harvest 1.5 bananas.

c. Labour mobility ensures a common wage in each sector, and competition ensures the price of
goods equal their cost of production. Thus, the relative price equals the relative costs, which
equals the wage times the unit labour requirement for apples divided by the wage times the unit
labour requirement for bananas. Because wages are equal across sectors, the price ratio equals
the ratio of the unit labour requirement, which is 3 apples per 2 bananas.

Question 11
a. The production possibility curve is linear, with the intercept on the apple axis equal to 160
(800/5) and the intercept on the banana axis equal to 800 (800/1).

b. The world relative supply curve is constructed by determining the supply of apples relative to
the supply of bananas at each relative price. The lowest relative price at which apples are
harvested is 3 apples per 2 bananas. The relative supply curve is flat at this price. The maximum
number of apples supplied at the price of 3/2 is 400 supplied by Home while, at this price, Foreign
harvests 800 bananas and no apples, giving a maximum relative supply at this price of 1/2. This
relative supply holds for any price between 3/2 and 5. At the price of 5, both countries would
harvest apples. The relative supply curve is again flat at 5. Thus, the relative supply curve is step
shaped, flat at the price 3/2 from the relative supply of 0 to 1/2, vertical at the relative quantity
1/2 rising from 3/2 to 5, and then flat again from 1/2 to infinity.

Question 12
a. The relative demand curve includes the points (1/5, 5), (1/2, 2), (2/3, 3/2), (1, 1), (2, 1/2).
b. The equilibrium relative price of apples is found at the intersection of the relative demand and
relative supply curves. This is the point (1/2, 2), where the relative demand curve intersects the
vertical section of the relative supply curve. Thus, the equilibrium relative price is 2.

c. Home produces only apples, Foreign produces only bananas, and each country trades some of
its product for the product of the other country.
d. In the absence of trade, Home could gain 3 bananas by forgoing 2 apples, and Foreign could
gain by 1 apple forgoing 5 bananas. Trade allows each country to trade 2 bananas for 1 apple.
Home could then gain 4 bananas by forgoing 2 apples, while Foreign could gain 1 apple by
forgoing only 2 bananas. Each country is better off with trade.

Question 13

The curve in the PPF reflects diminishing returns to labour. As production of Q1 increases, the
opportunity cost of producing an additional unit of Q1 will rise. Basically, as you increase the
number of workers producing Q1 with a fixed supply of capital, each additional worker will
contribute less to the production of Q1 and represents an increasingly large loss of potential
production of Q2.

Question 14
a. Draw the marginal product of labour times the price for each sector given that the total labour
allocated between these sectors must sum to 100. Thus, if there are 10 workers employed in
Sector 1, then there are 90 workers employed in Sector 2. If there are 50 workers employed in
Sector 1, then there are 50 workers employed in Sector 2. For simplicity, define P1 = 1 and P2 = 2
(it does not matter what the actual prices are in determining the allocation of labour, only
that the relative price P2/P1 = 2).

In competitive labour markets, the wage is equal to price times the marginal product of labour.
With mobile labour between sectors, the wage rate must be equal between sectors. Thus, the
equilibrium wage is determined by the intersection of the two P MPL curves. Looking at the
diagram above, it appears that this occurs at a wage rate of 10 and a labour supply of 30 workers
in Sector 1 (70 workers in Sector 2).
b. At this production point (Q1 = 48.6, Q2 = 86.7), the slope of the PPF must be equal to P1/P2,
which is 1/2. Looking at the PPF in Question 13b, we see that it is roughly equal to 1/2.
c. If the relative price of good 2 falls to 1.3, we simply need to redraw the P MPL diagram with
P1 = 1 and P2 = 1.3.

The decrease in the price of good 2 leads to an increase in the share of labour accruing to Sector
1. Now, the two sectors have equal wages (P MPL) when there are 50 workers employed in
both sectors. Looking at the table in Question 2, we see that with 50 workers employed in both
Sectors 1 and 2, there will be production of Q1 = 66 and Q2 = 75.8. The PPF at the production
point Q1 = 66, Q2 = 75.78 must have a slope of P1/P2 = 1/1.3 = 0.77.

d. The decrease in the relative price of good 2 led to an increase in production of good 1 and a
decrease in the production of good 2. The expansion of Sector 1 increases the income of the
factor specific to Sector 1 (capital). The contraction of Sector 2 decreases the income of the factor
specific to Sector 2 (land).

Question 15
a. The first step is to compute the opportunity costs of both cloth and food. We are given the
following resource constraints:
aKC = 2, aLC = 2, aKF = 3, aLF = 1 L = 2,000; K = 3,000
Each unit of cloth is produced with 2 units of capital and 2 units of labour. Each unit of food is
produced with 3 units of capital and 1 unit of labour. Furthermore, the economy is endowed with
2,000 units of labour and 3,000 units of capital. Given these values, we can define the following
resource constraints:
2QC + QF 2,000 Labour constraint
2QC + 3QF 3,000 Capital constraint
Solve these two constraints for the quantity of food produced:
QF 2,000 2QC
QF 1,000 2/3QC
This gives us two budget constraints for food production that must both be met. The production
possibilities frontier traces out these budget constraints for food and cloth production.

Looking at the diagram, we see that production of both food and cloth will take place when the
relative price of cloth is between the two opportunity costs of cloth. The opportunity cost of cloth
is given by the slopes of the two components of the production possibilities frontier above, 2/3
and 2. When cloth production is low, the economy will be using relatively more labour to produce
cloth, and the opportunity cost of cloth is 2/3 a unit of food. However, as cloth production rises,
the economy runs scarce on labour and must take capital away from food production, raising the
opportunity cost of cloth to 2 units of food.
As long as the relative price of cloth lies between 2/3 and 2 units of food, the economy will
produce both goods. If the price of cloth falls below 2/3, then the economy should completely
specialize in food production (too low a compensation for producing cloth). If the price of cloth
rises above 2, complete specialization in cloth will occur (too low a compensation for producing
food).
b. Note the input requirements for each good. One unit of cloth can be produced using 2 units of
capital and 2 units of labour. One unit of food is produced using 3 units of capital and 1 unit of
labour. In a competitive market, the unit cost of each good must be equal to the output price.
QC = 2K + 2L PC = 2r + 2w
QF = 3K + L PF = 3r + w
This gives us two equations and two unknowns (r and w). Solve for the factor prices:
w = PF 3r
PC = 2r + 2(PF 3r) = 2r + 2PF 6r = 2PF 4r
r = (2PF PC)/4
w = (3PC 2PF)/4
c. Looking at the two expressions in part (b), we see that an increase in the price of cloth will
cause the rental rate of capital to fall and the wage rate to labourers to rise. This makes sense,
as cloth is a labour-intensive good. An increase in its price will lead to greater production of cloth
and an increase in demand for the factor it uses intensivelylabour.
d. The capital stock increases to 4,000. The labour constraint will remain unchanged, keeping the
maximum price of cloth at 2 units of food. The new capital constraint is given by:
2QC + 3QF 4,000
Solving for QF yields:
QF 1,333 2/3QC
Thus, the minimum price of cloth is also unchanged at 2/3 units of food. The only difference now
is that the production possibilities frontier will have a larger horizontal intercept (if cloth is on
the horizontal axis). Compared to Figure 5-1, the new production possibilities frontier will
intercept the x-axis at 2,000 instead of 1,500.

e. The actual production point for cloth and food will depend on the relative prices of cloth and
food. If we assume that the economy is producing at a point such that all resources are being
utilized (point 3 in Figure 5-1), then we can compute the quantities of cloth and food by setting
the resource constraints equal to one another:
QF = 1,333 2/3QC = 2,000 2QC
2QC 2/3QC = 2,000 1,333
4/3QC = 667
QC = 500
QF = 1,333 2/3 500 = 1,000

f. Prior to the expansion of the capital stock, the economy was producing 750 units of cloth and
500 units of food. After the expansion, cloth production fell to 500, while food production
increased to 1,000. This is precisely what the Rybczynski effect predicts will happen.