Question

Suppose Home and Foreign countries (H and F) trade two goods, G1 and G2, and each country is populated with 2 workers (workers can split work time between two industries). At home, one worker can produce either 1 units of G1 or 2 units of G2 in one day. For foreign worker it takes 0.5 days to produce one unit of G1 and 0.2 days to produce one unit of G2.

(a) 5% Calculate the opportunity costs of producing G1 in each country.

(b) 5% Draw a diagram which shows Home country equilibrium with and without trade (production, consumption, relative price, and trade flows). Illustrate gains from trade in this diagram. (c) 5% Calculate real wage in the Home country before and after trade if free trade relative price of G1 is 2.5.

(d) 5% Calculate the world relative supply of G1 at the relative price p1/p2=2.2

Answer 1

Answer (a):

Opportunity cost is the loss of profit upon the selection of one alternative over another to produce the goods.

Calculation to identify the Unit labor required to produce units of G1 and G2 for both countries to find the Opportunity Cost is detailed as under:

Home Country (H):

• Requirement of unit labor for G1 (A) = 1
• Requirement of unit labor for G2 (B) = 0.5
• Opportunity cost of producing G1 in Home Country: A/B = 1/0.5 = 2

Foreign Country (F):

• Requirement of unit labor for G1 (C) = 0.5
• Requirement of unit labor for G2 (D) = 0.2
• Opportunity cost of producing G1 in Home Country: C/D = 0.5/0.2 = 2.5

Answer (b):

Home country equilibrium without trade

Gains from trade for Home country: Given the current production level for Home Country, if it can trade in to use more of foreign workers to produce the combination of G1 and G2, it will gain from trade. With trade, Home Country would be able to consume more of both, G1 and G2 without specialization.

Answer (c):

Real wage is calculated as the amount workers get paid / good price

Given: Free trade real price = 2.5

• Real wage prior to trade assuming zero profit (G1 (Wage/Price) = 1/unit labor requirement for G1) = 1/1 = 1
• Real wage after the trade = (Wage (G1)/Price (G2) = Price (G1)/A/Price (G2) = 1/1 * Price (G1)/Price (G2) = 1/1*2.5 = 2.5

Answer (d):

Relative price is in the middle of Opportunity Cost of G1 for home and foreign countries (2 < Relative Price of G1, 2.5).

• L1 = Total workers in home country
• L2 = Total workers in foreign country
• oCG1 = Opportunity cost for G1
• oCG2: Opportunity cost for G2

Relative quantity supplied is equal to: (L1/oCG1)/(L2/oCG2)

• oCG1 = 1
• oCG2 = 0.2

(L1/oCG1)/(L2/oCG2) = (2/1)*(2/0.2) = 1/5

Relative supply of G1 at relative price of 2.2 = 1 quantity over 5 quantities of G2