Question

Home is as described in problem 1. There is also another country, Foreign, with a labor force of 800. Foreign’s labor productivity in apple production is 1/5 apples per units of labor, while in banana production it is 1 banana per unit of labor.

Problem 1) Home has 1200 units of labor available. It can produce two goods, apples and bananas. The labor productivity in apple production is 1/3 apples per unit of labor, while in banana production it is 1/2 bananas per unit of labor.

Suppose Home and Foreign engage in free trade.

a)   Identify absolute advantage and comparative advantage of Home and Foreign.

b)   Describe the pattern of trade in the free trade equilibrium. Which theorem (law) do you use?

c)   One of the following three numbers is the relative price of apples in the free trade equilibrium. Which one is it?
(a) 2       (b) 1       (c) 0.2       (d) any of them is possible.

d)   Explain how Home gains from trade (hint: use your answer from question (c)).

e)   Explain how Foreign gains from trade (hint: use your answer from question (c)).

Answer 1

d)

Suppose home produce 400 apples and consumes 200 apples and exports 200 apples. Then it can import 400 bananas for 200 apples as the relative price of apples is now two banana/ apple. Therefore, at free trade equilibrium, it consumes 200 apples and 400 bananas. Before the trade, this 200 apple would cost 3/2 bananas/apple. Then the country could have consumed 200 apples for (200*3/2)bananas=300 bananas under autarky. Therefore, trade increases the consumption of banana without affecting the consumption of apples. Hence, trade poses a gain of 100 banana utility for home.

e)

Suppose F produce 800 bananas and consumes 400 bananas and exports 400 bananas. Then it can import 200 apples for 200 bananas as the relative price of bananas is now 2 banana/ apple. Therefore, at free trade equilibrium, it consumes 400 bananas and 200 apples. Before the trade, these 400 bananas would cost 5 apples/banana. Then the country could have consumed 400 bananas for (400*1/5) bananas=80 bananas under autarky. Therefore, trade increases the consumption of apples without affecting the consumption of bananas. Hence, trade poses a gain of 180 apple utility for F.