Question

Suppose that Spain and Italy both have 100 units each of capital and labor, and that they share the same CRS technology with which they produce wine and cheese. However, tastes differ in the two countries: consumers in Spain have a strong preference for cheese, and consumers in Italy have a strong preference for wine. Will there be trade? What would you expect the pattern of trade to look like? Do you think we can still talk about comparative advantage in this case?

1. What can you say about relative prices in autarky in the two countries? (Hint: drawing the autarky equilibrium for both countries should help).

2. Will there be trade? If so, what would you expect the pattern of trade to look like?

3. Do you think we can still talk about comparative advantage in this case?

Answer 1

We are given that both Spain and Italy have same number of capital and labor and they use same CRS technology to produce wine and cheese. This indicates that none of them have comparative advantage over other as of now.

Spanish consumers have a strong preference for cheese, and Italian ones have a strong preference for wine. This indicates that although both nations will produce same number of two goods, Spain will find its wine not being sold enough (due to lower demand) while cheese is being demanded more and more. The opposite will happen in Italy. Yes, there will be trade based on the preferences of the consumers to provide them greater varitey. The trade pattern will follow each country exporting its good which is not being sold (excess in supply) and will import the good which is short in demand (excess demand). Hence Spain will export wine and import cheese. Italy will export cheese and import wine.

1. We believe that the relative price of cheese in Spain must be higher than in Italy because of strong demand and so we expect the demand for cheese to shift over time. Similarly in autarky Italy must have a higher relative price of wine.

2. Spain will export wine and import cheese. Italy will export cheese and import wine.

3. Not at the present. As time passes the countries might decide to expand production of the good which they are importing so that in the long run they might not even produce the other good. Hence Spain might produce only cheese in long run and import only wine which will then be determined on the basis of comparative advantage.