PROBLEM SET 1 (ANSWER SHEET)

ECON 322, Spring 2016

6- Answer the following questions using the information given by the accompanying Table.
a) Complete the table for this problem in the same manner as Table 2-2 in the chapter.

Home Country Foreign Country Absolute Advantage

Number of bicycles 4 2 4/2=2 Home
produced per hour
Number of 6 8 6/8=0.75 Foreign
snowboards
produced per hour
Comparative 6/4= 1.5 8/2=4
Advantage (snowboards/bicyle) ; to to produce one extra
produce one extra bicycle 4 snowboards
bicycles 1.5 snowboard must be given up
must be given up

b) Which country has an absolute advantage in the production of bicycles? Which country has an
absolute advantage in the production of snowboards?

Home country has an absolute advantage in producing bicycles because it is twice more productive than
foreign country in producing bicycles.

Foreign country has an absolute advantage in producing snowboards because it is 1.33 (1/0.75) times
more efficient than home country in producing snowboards

c) What is the opportunity cost of bicycles in terms of snowboards at Home? What is the opportunity
cost of bicycles in terms of bicycles in terms of snowboards in Foreign?

Opp. Cost of a bicycle at Home in terms of snowboards =6/4 = 1.5

Opp. Cost of a bicycle in Foreign in terms of snowboards=8/2=4

d) Which product will Home export, and which product does Foreign export? Briefly explain why?

Foreign will export snowboards because the opportunity cost of snowboards is less in Foreign ( 2/8)
compared to that in Home country (4/6). Furthermore, Home country will export bicycles because the
opportunity cost of bicycles is less in Home country (1.5 ) compared to that in Foreign (4)

7-Assume that Home and Foreign produce two goods, TVs and cars, and use the information below to
answer the following questions.

a) What is the marginal product of labor for TVs and cars in the Home country? What s the no-trade
relative price of TVs at Home?

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b) What is the marginal product of labor for TVs and cars in the Foreign country ? What s the no-trade
relative price of TVs in Foreign?

In the No-Trade Equilibrium

Home Country Foreign Country

=12 =? =? =6

Due to labor mobility wages

= =6
should be equal across
industries

=2 =? =? =1

= / = /

= thus 6/3=2
12/4 =3

=? =4 =3 =?

Wages are equal to value

of Marginal Product: = /
*No trade relative
= * price of TV in Foreign= =6
= /
=12/2 =6, = 3/6

*No trade relative price

of TV at home=
=6/4 (car/TV)

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c) Suppose the world relative price of TVs in the trade equilibrium is =1 which good will each
country will export? Briefly explain why?

Foreign country will export TVs because the relative price of TVs in Foreign is cheaper than that in Home.
Remember, relative prices also equal the opportunity costs. Similarly, Home country will export cars

d) In the trade equilibrium, what is the real wage at Home in terms of cars and in terms of TVs. How do
these values compare with the real wage in terms of either good in the no-trade equilibrium?

i) Home country wage without trade

Real wage = = = 3 cars. This is equivalent to 3*4/6 =2 TVS [ (pre

trade) ]

ii) Home country wage with trade (exporting cars and =1 )

Real wage = = = 3 cars and , Real wage (in terms of TVs) =MPLC = 3*1 =3 TVS

It is clear that Home country gains from trade because the real wage has increased in terms of TVs.

e) In the trade equilibrium, what is the real wage in Foreign in terms of TVs and in terms of cars? How do
these values compare with the real wage in terms of either good in the no-trade equilibrium?

ii) Foreign country wage without trade

Real wage: =2 TVs. This is equivalent to 2*3/6=1 cars [=MPLTV* (PTV/PC) (pre-

trade)]

iI)Foreign country wage with trade (exporting TVs and =1 )

Real wage: =2 TVs. This is equivalent to 2*1=2 cars [MPLTV* (PTV/PC) after trade]]

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Similarly, foreign country gains from trade since their real wage increases in terms of cars.

f) In the trade equilibrium, do foreign workers earn more or less than those at Home, measured in terms
of their ability to purchase goods? Explain why.

They earn less than Home country workers because, although the pattern of trade is determined by
comparative advantage, real wages are determined by absolute advantage. In other words, home
country workers are more productive in producing cars and they are as equal productive as foreign
workers in producing TVS. This ensures higher wages at Home.

9- Suppose that the number of workers doubles in Home. What happens to the Home PPF and what
happens to the no-trade relative price of wheat?

a) There will be a parallel outward shift in Home PPF and relative prices will not change because slope
does not change with this shift (see Figure 1a)

b-i) There will be an anti-clockwise rotation of the Home PPF as described in Figure 1b. So, the relative
price of wheat which is the absolute value of the slope of PPF will decline. In other words, the
opportunity cost of an extra unit of wheat will decline. Since the relative supply of wheat has increased,
this is not a un- expected outcome.

b-ii) If a similar change occurred in the cloth industry, Home PPF will again pivot, but now in a clockwise
direction. The slope of the PPF increases. This means that the relative price of clothes will decline.

Clothes Clothes

100
Slope=-1
50

Slope=< |-1|

Slope=-1
Slope=-1/2
Wheat
100 200 Wheat

Figure 1 (a) Home) Figure 1(b) ( Home )

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11-Suppose that the Home country is much larger than the Foreign country. For example, suppose we
double the number of workers at Home from 25 to 50. Then Home is willing to export up to 100 bushels
of wheat at its no-trade price of Pw/Pc=1/2 rather than 50 bushels of wheat as shown in Figure 2-11.
We now draw a new version of Figure 2-11 with the larger home country.

Pw/Pc

Foreign Imports Home exports

D
1/2

50 80 100 Wheat

Figure 2

a)New world relative price of wheat ?

It will be yard/bushel

b) Using this new world equilibrium price, draw a new version of the trade equilibrium in Home and in
Foreign and show that production and consumption point each country .

See Figure 3a and 3b below.

The international terms of trade now equal the Home countrys no trade price ratio. The home country
(large country) will, therefore, produce both goods and will therefore not completely specialize. The
home country could produce 200 wheat and provide 80 wheat at relative price . In turn it will get 40
yards of cloth. So, it will not be able to benefit from trade since the international terms of trade simply
reflect Home countrys internal relative price ratio. However, in this case Foreign country can vastly
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benefit from trade. It will produce 100 yards of clothes. It can import 80 bushels of wheat in exchange
for 40 yards of clothes. This enables it to consume 80 bushels of wheat and 60 yards of cloths. If foreign
had consumed 60 yards of cloth without trade, it will have been able to consume only 40 bushels of
wheat.

Lesson: The more the international terms of trade move away from a countrys no trade relative prices,
the more it gains from trade.

Cloth
Cloth
Production point
100
Consumption 100
Consumption

40 Slope=-1/2
Production 60

Wheat
120 80 100
200
Figure 3 (a) Home) Figure 3(b) (Foreign )

Home country (large country) may not completely specialize. Think of US (large country) and Luxemburg (small
country). If Luxemburg exports all the clothes that it can to US, it still cannot satisfy total US demand for cloth. US
has to produce some clothes at Home. This means that international terms of trade will reflect USs internal relative
price ratio. For example, it could be as in Figure 4a.

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 Cloth
Cloth
Production point
100
Consumption 100
Consumption

Production
60 Slope=-1/2

20 60

80 160
200 80 Wheat
Wheat
Figure 4 (a) Home) Figure 4(b) (Foreign )

2-Base your answers to the following questions on the Ricardian trade model and on the Figures drawn
below:

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 Autarky PPF and CPF

Free Trade CPF

Chocolate Chocolate
s

Slope=-3
Slope=-3

Slope=-2

Slope=-6

Toothpaste
Toothpaste
Figure 4 (a) Dentinia) Figure 4(b) ( Insureland )

a. Insureland. We know this because a look at the figures reveals that the relative price of toothpaste is
UU

lower in Insureland in autarky. Notice that the relative price of toothpastes in Insureland and
UU

Dentinia are 2 and 6 chocolates, respectively.

b. Dentinia. We know this because a look at the figures reveals that the relative price of chocolates is
UU

lower in Dentinia in autarky. Notice that the relative prices of chocolate in Insureland and
UU

Dentinia are 1/2 and 1/6 toothpastes, respectively.

c. The figure below shows the gains from trade. Notice that each country ends up on a higher
consumption possibility frontier (CPF). This indicates that with trade both countries can consume
more than they produce. Under autarky, each country is constrained to consume what it
produces .
BB

Yes, each country generally completely specializes in one good. This is due to the assumption of
constant costs (recall the constant labor coefficients in the Ricardian model). A country can
continue to increase its production of the good that it has a comparative advantage in without
having to face increasing costs (unlike say the Heckscher-Ohlin model where production involves
decreasing returns/increasing costs).

Complete specialization is a feature of the Ricardian two country model although there is a possible
exception. When a small country trades with a country that is large enough, we can have a
situation where only the small country specializes (see question 11 above). This is because

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 consumers in the large country may still have unsatisfied demand even after the small country has
exhausted its capacity to export (think of Jamaica exporting bananas to China).

d. Technological differences (or, since labor is the only factor of production, differences in labor
productivities) determine relative prices in autarky. Once countries open up to international trade
and specialize, technological differences UUandUU international demand patterns determine the
relative price of commodities.

e. Technological differences (supply) and the international terms of trade determine relative wages
once countries have specialized according to their comparative advantage. As mentioned above,
the terms of trade, in turn, are determined by international demand.