Question

Consider a two-country, two-goods world. Trade is based on comparative advantage. You are given the following information (which applies to the whole question, unless otherwise stated): • One labour can produce 20 toasters (T) or produce 40 ovens (O) in Home (H); while one unit of foreign labour can produce 25 units and 50 units of toasters and ovens respectively.

• The labour endowment in Home is 500, which is one-hundred units more than Foreign.

• The free-trade relative price of toaster is the average of the countries’ autarky relative prices.

• Both countries agree to trade 3400 toasters. Note: Keep your answer to 2 decimals places if needed.

a) Is there any gain from trade? Yes/No, explain. (5 points) Yes, both countries will gain from trade, because the consumption of goods will increase after the trade.

b) Suppose a new production technology is available for ovens such that the level of productivity increases by 10% in Home. Compute the free-trade relative price of toaster. Find the production and consumption bundles for Home. (6 points)

c) (Continued from part b) Suppose the new production technology for ovens is also available to Foreign such that the level of productivity increases by 4% in Foreign. Redo part (b). (6 points)

d) Show your answers in parts (b) & (c) in a well-labeled diagram (label toasters on the horizontal axis). Also, remember to identify Home’s levels of exports and imports, and label the slopes of the PPFs and budget constraints. No need to include the indifference curves and no written explanation is needed. (13 points)

Answer 1

	TOASTER	OVEN
HOME	20	40
FOREIGN	25	50

GIVEN THAT IN THE TWO COUNTRY TWO COMMODITY MODEL TRADE WILL HAPPEN BASED ON COMPARATIVE ADVANTAGE THEORY. COMPARATIVE ADVANTAGE DEFINES THAT IS ONE COUNTRY HAS ABSOLUTE ADVANTAGE IN PRODUCTION ( HERE HOME) THEN ALSO TRADE WILL OCCURE IF THE DOMESTIC COST RATIOS OF BOTH THE COUNTRIES DIFFER.

DOMESTIC COST RATIO OF DOMESTIC COUNTRY = 20 / 40 = 1/2

DOMESTIC COST RATIO OF FOREIGN COUNTRY = 25 / 50 = 1/2

SINCE DOMESTIC COST RATIOS OF BOTH THE COUNTRIES ARE EQUAL THUS TRADE WILL NOT OCCURE BETWEEN THEM FOLLOWING COMPARATIVE ADVANTAGE THEORY.