Question

Suppose two countries Mexico and Canada both produce two goods wheat and coffee, suppose the relative price of wheat in Mexico is 2.5 but in Canada it is 0.5. If they both specialize based on comparative advantage and trade, what will be the range of possible global relative price of coffee that trade will converge to, providing both countries mutual gains from trade. Assuming the resource used in producing wheat and coffee is homogeneous, what will happen to the wheat production and wages in Mexico? In Canada? Why? Explain why if the hourly payment to the homogeneous resource employed in both countries was different before trade that it will still be different after trade.

Answer 1

Mexico and Canada both produce wheat and coffee. Currently the relative price of wheat in Mexico is 2.5 in terms of coffee which reflects the opportunity cost of producing 1 unit of wheat. The same in Canada it is 0.5. Now we see that the opportunity cost of wheat is lower in Canada so when they both specialize based on comparative advantage and trade, Canada will be producing and exporting wheat while Mexico will produce coffee. In this sense the opportunity cost of coffee in Mexico is 1/2.5 = 0.4 units of wheat and the same in Canada is 1/0.5 = 2 units of wheat

Usually, the range of possible global relative price of a product is given by its opportunity cost of production by two countries indulged in trade. Here the range of relative price of coffee that trade will converge to will lie betwee 0.4 units to 2 units of wheat. providing both countries mutual gains from trade.

As a result of trade, wheat production in Mexico falls and so is the demand for labor and the wage rate associated with it. However, as the demand for labor is increased in the coffee production, the same displaced labor is employed by the coffee industry and so the wages of coffee workers will increase in Mexico. We thus observe that overall the wage bill or total income of workers remain unchanged, although there is an increase in the wage rate of coffee workers and a reduction of wheat workers.

In Canada, the opposite happens. As a result of trade, coffee production falls and so is the demand for labor and the wage rate associated with it. As the demand for labor is increased in the wheat production, the wages of wheat workers will increase

If the hourly payment to the homogeneous resource employed in both countries was different before trade, it will still be different after trade for the same reason because the wage rate in comparatively disadvantageous industry will fall and in comparatively advantageous industry will increase.