Question

Suppose that you are the executive manager of the manufacturing team for a clothing company that is located in the U.S. Your company is interested in expanding its international activities by producing two new products; jackets and sweaters. It considers two countries; China and/or Italy. China has 1200 units of labor available. It can produce two goods, jackets and sweaters. The unit labor requirement in jacket production is 3, while in sweater production it is 2. Italy has a labor force of 800. Italy’s unit labor requirement in jacket production is 5, while in sweater production it is 1.

You are asked by the CEO to report the following information:

1. Identify absolute advantage and comparative advantage of China and Italy.

  

2. Describe the pattern of trade in the free trade equilibrium. Please provide a brief explanation for your answer.

3. One of the following three numbers is the relative price of jackets in the free trade equilibrium. Which one is it?

(a) 2                      (b) 1                (c) 0.2             (d) any of them is possible.

Problem 2

Suppose that the information given in Problem 1 applies.

        a) Suppose now that you have to convince the Chinese government that your business will benefit their country. How would you prove this? (Hint: You can use a graph to support your answer).

b) Suppose now that you have to convince the Italian government that your business will benefit their country. How would you prove this? (Hint: You can use a graph to support your answer).

Answer 1

China has 1200 units of labor available. Thus, China can either make 400 units of jackets or 600 units of sweater.

1) Again, Italy has 800 units of labor available. Thus, Italy can either make 160 units of jackets or 800 units of sweater.

a. Here, no country has absolute advantage in both goods. However, China has comparative advantage in production of jackets whereas, Italy has comparative advantage in the production of sweaters.

b. Under free trade equilibrium, China will specialize in jacket production and Italy will specialize in sweater production. Thus, China will export jackets and import sweaters whereas, Italy will export sweaters and import jackets.

Here, terms of trade must lie between relative price in China and relative price of Italy

i.e., 1.5 sweaters per jacket in China < TOT < 5 sweaters per jacket in Italy.

c. Here, only 2 lies in between terms of trade (or relative price in terms of jackets) for both the countries. Thus, option a is the correct answer.

2. Suppose U.S can either make 250 units of jackets or 750 units of sweaters i.e, relative price in U.S is 3 sweaters per jacket.

a) In comparison to China, U.S has comparative advantage in the production of sweaters (China has comparative advantage in the production of jackets). If world relative price is 2 sweater per jacket, then, we can show the benefits from trade in the diagram below :

Thus, China will gain 100 sweaters and U.S. will gain 62.5 jackets from trade.

b) a) Now, in comparison to Italy, U.S has comparative advantage in the production of jackets (Italy has comparative advantage in the production of sweaters). If world relative price is 4 sweater per jacket, then, we can show the benefits from trade in the diagram below :

Thus, Italy will gain 20 jackets and U.S. will gain 125 sweaters from trade.

From 2.a and 2.b, we can see that U.S. will gain both goods from trade.