Sample Problems and Solutions lecture 3

Problem 4 in the Textbook Consider the two economies shown in Figure 3.1 When there is free trade, are we sure that each country should specialize completely in producing only one of the products? For instance, perhaps each country should shift along its PPC only about halfway from the no-trade production point S0 to the intercept point S1. If the countries still trade with each other at the relative price of 1W/C would production at the halfway point be better or worse for each country (compared to completely specializing at point S1)? We are assuming constant marginal costs. So under this assumption under free trade it is always better for each country to completely specialize in only one of the products – this would give each country the best set of consumption points than shifting only mid-way between S0 and S1. (See pages 44-45 of Chapter 3 in 14th edition of textbook). 2> Problem 7 in the Textbook You are given the following information You make several Ricardian assumptions. These are the only two commodities, there are constant ratios of input to output whatever the level of output of rice and cloth, and competition prevails in all markets. a. Does Pugelovia have an absolute advantage in producing rice? Cloth? • In neither since in the case of both rice and cloth it requires higher inputs per unit compared to RoW b. Does Pugelovia have a comparative advantage in producing rice? Cloth? • You can write the relative price table to figure this out. So each country has a comparative advantage in the good in which it has lower opportunity cost (relative price). From the table, it is clear that Pugelovia has a comparative advantage in producing rice (its opportunity cost is 0.75C/R which is < 1 C/R in RoW). c. If no international trade is allowed, what price ratio should prevail between rice and cloth within Pugelovia? • With no trade, the price ratio in Pugelovia should be 0.75C/R d. If free international trade is opened up, what are the limits for the equilibrium international price ratio? What will Pugelovia export and import? • With trade, the 0.75C/R ≤ International Price Ratio ≤ 1C/R • Pugelovia will export rice (in which it has comparative advantage) and import cloth.