PrinciplesofInternationalEconomics 04May2017

Exercise2

1. Twocountriesproducetwogoods,usinglaborasonlyfactorofproduction.Thelabor
endowmentsareL=L*=100.Inautarkyfactorprices(wages)arew=w*=1.


Theproductionfunctionsare: , and ,



Thedemandfunctionsare , and ,

a. Drawtheproductionpossibilitiesfrontierforthetwocountries.

ThemaximumamountofwinethatHomecan
produceis 100andthemaximum
amountofwineis 50.Equally,
Foreigncaneitherproduce50unitsofcheeseor
33,3unitsofwinewhenallocatingalllaborintoone
ofthesegoods(specializing).

b. Calculatethelaborinputcoefficientsforbothgoodsinbothcountries.

Theunitlaborcoefficientforagoodisanindicatorfortheunitsoflaborneededforoneunitofthat
good.

IncaseofcheeseproductioninHometheproductionfunction signifiesthatanyamountof
labourdividedby1equalsanumberofproducedgoods.Inordertofindouthowmuchlaborisneeded
foronesingleunitofoutput,weset to1(for1unitofoutput),whichgivesus1 .Remodelling
theequationgivesus 1.Ergo,1unitoflaborisneededfor1unitofoutput,or,inotherterms,
theunitlaborcoefficientforHomescheeseproductionis 1 .ForHomeswineproductionthe
amountoflaborisdividedby2( ),thusweneed2unitsoflaborforoneunitofoutput 2 .

FollowingthisprocedurefortheproductionsinForeign,wereceive 2and 3.

c. Calculatetheunitcostsofproductionforbothgoodsinbothcountriesinautarky.

Thepriceofagoodisdeterminedbyitsunitoflaborcoefficientandbywages .Whenin
autarky(notrade)wagesequal1inbothcountries.

OneunitofcheeseinHomecosts 11 1,andoneunitofwineinHomecosts
2 1 2.

OneunitofcheeseinForeigncosts 21 2,andoneunitofwineinForeigncosts

3 1 3.

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 PrinciplesofInternationalEconomics 04May2017
Exercise2

d. Determinetheautarkyequilibriaandthefreetradeequilibrium.

Equilibriuminautarky(notrade)meansthatalldomesticallyproducedgoodsareconsumedby
domesticdemand.

Thedemandfunction signifiesthatconsumersofHomearewillingtospend oftheirtotal

income(totalincomebeing )onproduct1(cheese): 66,7unitsofcheeseisbeing
demanded.Theremaining oftheirincomeisbeingspendonwine: 16,7unitsofwine.
AutarkyequilibriumforHomeisat66,7unitsofcheeseand16,7unitsofwine.

SameprocedureforForeign:autarkyequilibriumisat 33,3unitsofcheese


and 11,1unitsofwine.

Equilibriuminautarky

E1:equilibriumforHome
E2:equilibriumforForeign

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 PrinciplesofInternationalEconomics 04May2017
Exercise2

Inordertodefinethefreetradeequilibriumweneedto:

1) Definethemaximumquantitiesproducedbyeachcountry

Infreetrade,bothcountriesspecializeontheproductionofthatgoodinwhichtheyhave
comparativeadvantage.Thus,Homewillspecializeoncheese(producing100units)andForeignwill
specializeonwine(producing33,3units).So, beingthetotalamountofcheeseonthefreetrade
marketequals100,and 33,3.

2) Definetheoverallwagerateforbothcountriesinfreetrade

Infreetradeallproducedgoodsareequalthetotalamountdemanded: and

.Wagesinfreetradeareunknown,soletsassumethattheoverallwagerateinHomeis
1.NowweneedtocalculatetheoverallwagerateinForeign:


100 0,5

3) Definethefreetradepricesforbothgoods

SinceHomeistheonlyoneproducingcheese,thefreetradepriceforcheesewilldependonthe
productioncostofHome: 11 1.So,thefreetradepriceforcheeseis 1.

ThefreetradepriceforwinewilldependontheproductioncostsinForeign:
0,5 3 1,5.

4) Howmuchwillbeimported/exportedwhereistheequilibrium?

Homedemands 66,7unitsofcheese.Theyalreadyproduce100,sotheycan

exportthesurplus(33,3unitsofcheese).
,

Foreigndemands 33,3unitsofcheese,whichtheywillneedtoimport

exactlytheamountHomecanexport.

Homesdemandforwineis 22,2whichtheywillneedtoimport,astheydonot
,
produceanywine.
,

Foreignsdemandforwineis 11,1andsinceForeignproduce33,3unitsof
,
wine,theycanexportthesurplus(22,2)toHomewhichhappenstobeexactlythesameamount.

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 PrinciplesofInternationalEconomics 04May2017
Exercise2

e. Whichcountryhasanabsoluteandwhicharelativeadvantage?

Thefirstcountry(Home)hasanabsoluteadvantageasithasahigherproductivityinproducingboth

goods: and .Homealsohasacomparativeadvantageinproducingthefirstgood

(cheese) 0,5 0,67.Ontheotherhand,Foreignhascomparativeadvantageinproducing

thesecondgood(wine) 2 1,5.

f. Aretheregainsfromtrade?

Yes.ForHomepricesforthefirstgood(cheese)didnotchange,butitdidfortheother(wine):from2
to1,5.Thishadaneffectonitswineconsumptionwhilstcheeseconsumptiondidnotchange,wine
consumptionrosefrom16,7inautarkyto22,2infreetrade.

ForForeignallpricesdroppedby50%,butsodidtheirrelativewagerate(from1to0,5).Theamount
ofgoodsconsumed,however,didnotchangefromautarkytofreetrade.

g. Howtowagesdifferinthefreetraderegime?

Inthisexample,oncethecountrieshavespecialized,allHomeworkersproducecheeseandall
Foreignworkerproducewine.Thepriceforcheeseinfreetradeis1(letssay1)perunitofcheese
and1,5forwine.SinceHomeonlyneedsonehourforoneunitofcheese,Homesworkerswillearn
1perhour(perunitoflabor).Foreign,however,needs3hourstoproduce1unitofwine,sotheper
,
hourincomeis 0,5foraForeignworker.SorelativewagesinHomearetwiceashighasin
Foreign.

Bothcountriesendupwithacostadvantageinonegood.Becauseofitslowerwagerate,Foreignhas
acostadvantageinwine(eventhoughlowerproductivity).Homehasacostadvantageincheese,
becauseofitshighproductivity(whichcompensatesforthehigherwagerate).

2. Markthetruestatements

a. IntheRicardomodeltherealwagerateissmallerinthecountrythathasanabsolute
advantageintheproductionofbothgoods.

False.Therealwagerateishigherinthecountrywithabsoluteadvantage.

b. Tradepatterns(andgainsfromtrade)aredeterminedbyabsoluteadvantage.

False,tradepatternsaredeterminedbycomparativeadvantage.

c. IfthehomecountrymaximizesGDP,italwaysproducesbelowitsProductionPossibility
Frontier.

False.WhenproducingbelowPPF,acountryisbeinginefficient.

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