In: Economics
Consider two countries, Germany and Italy, which produce two goods, beer and cheese. The labour requirements (in hours) for producing one unit of these goods in each country are:
Beer |
Cheese |
|
Germany |
aLB = 2 |
aLC = 3 |
Italy |
aLB* = 5 |
aLC* = 4 |
Which country has the absolute advantage in the production of beer and which in the production of cheese? (Mark: 0.2)
Which country has the comparative advantage in the production of beer and which in the production of cheese? Describe the pattern of trade. (Mark: 0.6)
Determine the range of the international relative price defined as the price of beer over the price of cheese. (Mark: 0.2)
d) Suppose that the international relative price is |
Pbeer |
= 0.8 . Find the relative wage |
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P |
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cheese |
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rate |
WItaly |
and explain why the country with the higher wage, as well as the |
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W |
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Germany |
country with the lower productivity, can be competitive in the good they specialize. (Mark: 1.0)
You need not state the definitions of AA and CA. The definitions are mentioned for the purpose of understanding the problem at hand.
a. Absolute Advantage (AA): When a country or an individua is more or absolutely efficient at producing a particular good than his/her rival country or individual, then the country or individual has an AA in the production of that good.
Germany has AA in Beer (It takes two hours to produce one unit of beer in Germany whereas it takes five hours to produce one unit of beer in Italy).
Similarly, Germany has AA in Cheese (It takes three hours to produce one unit of cheese in Germany whereasit takes four hours to produce one unit of cheese in Italy)
b. Comparative Advantage (CA): If a country or individual is relatively more efficient in the production of a good than another country or individual then we say that he/she has comparative advantage in production of that good. Comparative advantage measures efficiency in terms of relative magnitudes.
Relative price of Beer in Germany: (aLB / aLC) = 2/3 = 0.67
Relative price of Beer in Italy: (aLB*/aLC*) = 5/4 = 1.25
Germany has CA in beer as beer is cheaper in Germany. (aLB/aLC < aLB*/aLC*)
Relative price of Cheese in Germany: (aLC / aLB) = 3/2 = 1.5
Relative price of cheese in Italy: (aLC*/aLB*) = 4/5 = 0.8
Italy has CA in cheese as cheese is cheaper in Italy. (aLC*/aLB* < aLC / aLB)
Pattern of Trade: Since Germany has CA in beer, it should specialize and produce more of beer. Italy has CA in cheese and hence should specialize and produce more of cheese.
c. Range: (aLB/aLC)G < PB/PC < (aLB*/aLC*)I = 0.67 < PB/PC < 1.25
d. Autrky wages in units of goods are just the reciprocals of the respective unit labor requirements.
Germany: wG/pB = 1/aLB = 1/2 = 0.5, wG/pC = 1/aLC = 1/3 = 0.33
Italy: wI/pB = 1/aLB* = 1/5 = 0.2 ,wI/pC = 1/aLC* = 1/4 = 0.25
Since wages depend on price ratio, it follows:
Germany: wG/pB = (wG/pC)(PB/PC) = (0.33)(0.8) = 0.264
Italy: wI/pc = (wI/pB)(PB/PC) = (0.2)(0.8) = 1.6
WItaly/WGermany = 1.6/0.264 = 6.06