Question

Consider the following scenario.

(1) France and Italy only trade with each other;
(2) each country is only capable of producing 2 goods, Wine and Bread;
(3) the production of Bread is relatively capital intensive, and the production of Wine is relatively labor intensive, and
(4) France is relatively abundant in capital, while Italy is relatively abundant in labor. All assumptions from our class about the Heckscher-Ohlin model hold, in particular the fact that both countries have identical homothetic preferences, constant returns to scale in production, the countries are the same size, etc...

For the sake of consistency, put BREAD on the X-axis of any PPF graphs you might be inclined to draw.

a. Compare the relative prices of Wine and Bread in each country under autarky. Be sure to thoroughly explain your answer, possibly using a graph(s) for a visual aid. (Answer should be at least one paragraph in length. Quality of your answer determines grade.)
b. Sketch excess demand/excess supply curves for Bread consistent with the scenario when the countries open for free trade. Be sure to carefully draw your graph and identify all relevant parts.
c. Describe what happens to factor payments in France with trade. Be sure to thoroughly explain your answer using what you have learned from the class. (Answer should be at least one paragraph in length.
d. Academic research on alcoholism induces a change in preferences for the goods. In both countries, Wine becomes less desirable relative to Bread. In words and possibly with pictures, describe the impact of this change in preferences on the two economies. You should be sure to include a discussion on the changes in the prices of goods and production factors.

Answer 1

Consider the given problem here there are two goods “bread” and “wine”. So, here “bread” is capital intensive good and “wine” is labor intensive good. Now, there are also two country “France” and “Italy”, where “France” is relatively capital abundant and while “Italy” is labor abundant. If we measure “bread” on the “X” axis and “wine” on the “Y” axis, => the PPF of “France” is biased towards “bread” that is “X - axis” and the PPF of “Italy” should be biased towards “wine” that is “Y - axis”. Consider the following fig.

So, since the PPF of “France” is biased towards “bread” and PPF of “Italy” is biased towards “wine”, => the autarkic relative price of “bread” should be lower in “France” compare to “Italy”. Similarly, the autarkic relative price of “wine” should be lower in “Italy” compare to “France”.

b).

Consider the following fig.

Now, as “France” is relatively capital abundantand “bread” is capital intensive good implied the PPF of “France” is biased towards “bread”, => the relative supply of “bread relative to wine” should be more for “France” compare to “Italy”. So, in the above fig we can see that “RSBf” be the “relative supply of bread for France” and “RSBi” be the “relative supply of bread for Italy”. So, as both the country have same types of test and preference, => given the “RD for bread”, the autarkic equilibrium relative price of bread is less in “France” compare to “Italy”. Now, the autarkic equilibrium relative price of wine is less in “Italy” compare to “France”.

c).

So, in the above fig we can see that the autarkic relative price of bread in France is less than Italy, => “France” has comparative advantage in the production of “bread” and “Italy” has comparative advantage in the production of “wine”, => trade between both the country is possible. Now, if they trade to each other then the relative price will converge and will be between “pi” and “pf”.

Now, as France is capital abundant country, => labor is scarce factor in France, => at the autarkic situation the “price of capital” must be lower than “Labor”. Similarly, Italy is labor abundant country, => capital is scarce factor in Italy, => at the autarkic situation the “price of capital” must be lower than “Labor”. So, as the trade open between two country, => the relative price will converge in two country, => as the trade open then the return on labor increases and the for capital decreases in “Italy”. Similarly, the return on labor decreases and the for capital increases in “France”.

d).

Now, as “bread” become more desirable compare to wine in both the country, => the “RDB” will decreases implied the “autarkic relative price of bread” in both the country decreases. So, still the “autarkic relative price of bread” in France will be less than Italy. So, “France” has comparative advantage in the production of “bread” and “Italy” has comparative advantage in the production of “wine”, => trade between both the country is possible. So, as the trade open between two country implied the relative price will converge