04 Jun Question 1. There are two countries, Home and Foreign, who
Question
1. There are two countries, Home and Foreign, who produce two goods Food and
Clothing, using one factor of production, Labor. The unit input require- ments are
given by the table below in the two countries.
Good\Country
Home
Foreign
Food
3
9
Clothing
5
3
Home has 60 units of labor while foreign has 90 units. Food is consumed in
a one to one ratio relative to clothing at all prices by both countries. Use graph
paper below. A sheet is attached.
a.
(i) Draw the PPFs for each country and the world PPF under trade. What is
the opportunity cost of a unit of food in terms of clothing at home and abroad?
(ii) If the price of clothing is 1, what is the price of food under autarky in
each country and under free trade? In other words, what is the equilibrium
relative price of food under autarky and free trade.
(iii) What are equilibrium wages (what a unit of labor earns) in each country
under trade?
(iv) Who gains from trade and why? Does any country lose from trade?
b. Depict the trading equilibrium and the prices, production, imports and
exports by each country in your graph. You do not need to solve for it algebraically, just to depict it on paper.
c. Suppose productivity at home doubled, that is, the unit labor requirements
halved.
(i) What happens to world prices? Does the foreign country gain or lose from
home becoming more productive? Does home gain from its productivity
improvement?
(ii) In view of your answer to part (i) just above, comment on whether
economically small countries are more ore less likely to gain from trade.
d. When Chinese productivity rises, their supply shifts out and the world prices for
goods they export fall. This is good for the rest of the world though the Chinese
may find that they are gaining less than their productivity improvement would
suggest due to adverse terms of trade effects. Comment in view of your answers
to part c. above.
e. Depict the PPF for the world assuming labor is internationally mobile.
f. Can the PPF when labor is mobile between countries lie strictly outside the
world PPF through trade or must it touch it somewhere? Can you give conditions
under which they would touch at some point and when they would not? (Hint:
consider what happens when one country has an absolute advantage in both goods
and when this is not the case.)
g. Given your answers to part f., how would you respond to the following quote:
Given the lack of trade barriers today, there are orders of magnitude more gains
to be had from permitting labor migration than trying to further liberalize trade.
h. What do you think you learnt from studying the Ricardian model of trade?
2. Developia produces two goods, manufactures and food, using three factors of
production: capital, land and labor. The production of manufactures requires
capital and labor, while the production of food uses land and labor. All the arable
land is in the south while all the factories are in the north. Labor is mobile between
regions and sectors. The economy faces a given world prices of cloth and food,
and has given endowments of capital, land, and labor. Let the price of cloth be
one.
a. Explain how to draw the PPF.
b. What is the effect on the allocation of labor between sectors and of output of the
two goods in Developia of a freeze in the rest of the world that resulted in an
increase in the world price of food.
c. How does this affect the production point along the PPF?
d. What is the effect of the freeze on the nominal and real earnings of each of the
factors?
e. The freeze also results in migration into Developia. What is the effect of this
migration on the post freeze equilibrium? In particular, what happens to the PPF,
to the output and to the nominal and real earnings of the three factors?
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