Question

Suppose there are two countries Thailand and Vietnam. Both countries produce banana and textile from two factor inputs, labor and land. While Thailand is land-abundant, Vietnam is labor-abundant. Finally, both countries are identical in consumer's preferences (i.e., consumers always choose the equal quantity of the two goods, for example) and production techniques (i.e., production technique for banana is land-intensive and that for textile is labor-intensive).

1. Consider the production possibility frontiers for the two countries that are appropriate to the assumptions above. Assume that both countries have no access for international trade (autarky). Under the autarky equilibrium, which country has the higher price of textile relative to banana? Thailand or Vietnam?

2. Now consider the free trade equilibrium. (1) In order for both countries to benefit from trade, we need to introduce an appropriate international relative price (term of trade). Briefly discuss the condition so that both countries can increase their welfare. (2) Over the transition from the autarky to the free trade equilibrium, which country experiences the rise of the price of textile relative to banana? Thailand or Vietnam?

Answer 1

1.Thailand

2.(1) Terms of trade are defined as the ratio between the index of export prices and the index of import prices. If the export prices increase more than the import prices, a country has a positive terms of trade, as for the same amount of exports, it can purchase more imports. Since both countries have identical consumer preferences but contrasting resource allocations, both countries can benefit by relative price changes in the cost of the two products brought about by the introduction of international trade.

(2)Vietnam