Question

Consider two countries, Green (Home) and Purple (Foreign), which produce butter and jam. There is only one factor of production (labor). In order to produce a pound of butter, a Home worker needs 5 hours, while a Foreign worker needs 4 hours. In order to produce a pound of jam, a Home worker needs 4 hours, while a Foreign worker needs 3 hours. Markets are perfectly competitive. Labor endowments are equal across countries:

L = L* = 3300 hours

a) What are the unit labor requirements for each product (butter and jam) in each country? What is the opportunity cost of a pound of butter in terms of pounds of jam in Home? And in Foreign?

b) What country has a comparative advantage in which good and why?

c) Draw the production possibility frontiers for Home and Foreign, in two separate graphs. In each, place butter on the horizontal axis and jam on the vertical axis.

d) Draw the world relative supply, with the relative price of butter in terms of jam on the vertical axis, and the relative quantity of butter on the horizontal axis

e) Draw the world relative demand curve that crosses the relative supply curve at a point such that the relative price of butter is 1.29 pounds of jam. What good (or goods) will Home produce at this price? What good (or goods) will Foreign produce at this price?

f) In two new, separate graphs draw the consumption possibility frontiers for Home and Foreign when the relative price of butter in terms of jam is 1.29. Are there gains from trade for Home? Why or why not? And for Foreign? Why or why not?

g) Now assume that the relative demand shifts and crosses the world relative supply at a relative price equal to 1.25 pounds of jam for a pound of butter. Draw the new consumption possibility frontiers for Home and Foreign in two separate graphs. At this different relative price, are there gains from trade for Home? And for Foreign? Why or why not?

Answer 1

a).

Here home worker can produce a pound of butter by 5 hours of labor or a pound of jam by 4 hours of labor, => the labor requirement for butter and jam are “5” and “4” respectively. Similarly, foreign worker can produce a pound of butter by 4 hours of labor or a pound of jam by 3 hours of labor, => the labor requirement for butter and jam are “4” and “3” respectively.

Here the opportunity cost of producing 1 pound of butter is “5/4 pound of Jam” for home country and the opportunity cost of producing 1 pound of butter is “4/3 pound of Jam” for foreign country.

b).

Here home country having lower opportunity cost of butter compare to the foreign country, => home country have a comparative advantage in the production of butter and foreign country have a comparative advantage in the production of jam.

c).

Given the information provided the PPF of home country is, => 5*B + 4*J = 3300, where “B=Butter” and “J=Jam”. The following fig, where A1B1 be the PPF of home country.

The PPF of foreign country is, => 4*B + 3*J = 3300, where “B=Butter” and “J=Jam”. The following fig, where A2B2 is the PPF of foreign country.

d).

The following fig shows the world relative supply curve of butter.

Here the relative price is less than “5/4 = 1.25” then both the country will specialize to the production of jam, => the relative supply of butter is “0”, => the relative supply is given by “OA1” line. Now, if it is between “5/4” and “4/3” then the home country will specialize to the production of butter and the foreign country will specialize to the production of jam, => the relative supply is vertical that is A2B1. Now, for relative supply equal to “4/3 = 1.33” the home country will specialize to the production of butter and the foreign country can produce any combination of butter and jam on its PPF, => the relative supply is horizontal here.