Question

Suppose Home has 2,000 units of labor available. It can produce two goods, clothing (C) and wheat (W). The unit labor requirement in clothing production is 5, while in wheat production it is 2. Home is as described above. Now suppose there is another country, Foreign, with a labor force of 3,000. Foreign’s unit labor requirement in clothing production is 2, while in wheat production it is 4.

a. Which country has an absolute advantage over the other in clothing production? Which has a comparative advantage over the other in wheat production?

b. What and how much do Home and Foreign produce, respectively, when the world relative price of clothing is 0.5, i.e., p_C/p_F = 0.5?

c. What is the range for the relative price of clothing under free trade?

d. Suppose the world relative price of clothing under free trade is 2, i.e., p_C/p_F = 2. Describe the pattern of trade between Home and Foreign?

e. Show that both Home and Foreign gain from trade at p_C/p_F = 2? .

Answer 1

A. Foreign had an absolute advantage in clothing as the unit labor requirement is low for clothing.

Whereas home had an absolute advantage in wheat production. As unit labour req. Is 2<4.

B. Foreign has comparitive advantage in production of clothes. As alc/alw= 1/2

Whereas for home, alc/alw=2.5

Therefore since foreign has CA in clothes, foreign will produce clothes and home will produce wheat.

Now since pc/pf=1.5

As it is exactly equal to foreign's opportunity cost ofclothing production. Foreign will produce both clothes and wheat.

And since alc(h)/alw(h)=2.5>1.5. so home will produce only wheat and will exchange it for clothes at the world price.

Since all labour is into wheat in home, wheat produced= total labour/ alw= 1000units of wheat in home..

Foreign can produce both both wheat and clothes.

C. Under free trade, the relative price would have to be in between the two opportunity costs. Only then it will be beneficial for both countries to trade.

Thus,1.5 <PC/pf<2.5.

D. If world free trade price is 2,

Home will produce only wheat Andand would trade it for clothes and foreign will produce only clothes and would trade it for wheat.

E. At pc/pf=2

Home can produce wheat using 2hours of labour. It can exchange this wheat for 1/2 clothes. Whereas if it produced clothes itself, it would take 2.5 hours for home to produce 1/2clothes itself

Similarly foreign will produce only clothes. Using 2 hours of labour, 1 unit of clothes will be produced which will then be exchanged by 2 units of food. If foreign had utilised those 2 hours in wheatit would have produces just 1/2 wheat. But through trade it is indirectly producing 2wheat.

Thus both countries benefit through indirect production of both wheat and clothes.