Consider a two countries, Portugal and England, that produce two goods, wine and cheese, with only one factor of production, Labor. In Portugal, one unit of labor can produce 1 unit of wine or 1 unit of cheese. In England, one unit of labor can produce 1 unit of wine or 2 of cheese. There are 100 units of labor in Portugal, and 100 in England. Countries share the same tastes, and there is perfect competition.
1) Fill in the following table:
Portugal |
England |
|
Wine |
||
Cheese |
||
Labor |
||
PW/PC |
||
PC /PW |
Remember that the production possibilities frontier is the combination of wine and cheese that can be produced in each country, given resources (in our case, given the amound of labor).
Remember that for equilibrium we want to know how much each country is producing and consuming of each good, and at what price (Hint: you will NOT yet be able to give a precise numerical answer.)
a) Suppose now that preferences are such that consumers in both countries (remember, tastes are the same across both countries) always want to consume twice as much cheese as wine. What would the autarky equilibrium be? (Now you can give me a precise number!)
(Note that when you read “relative price of cheese” this is means “price of cheese relative to wine” or PC/PW and vice versa)
Does the pattern of trade change? Does the level of production change? Do the gains from trade change? If so, specify how (numerically if possible, qualitatively – increases or decreases if not).
For the gains from trade, look carefully at how the Consumption Possibilities changes with the new price.
PORTUGAL | ENGLAND | |
Wine | 1 labor | 1 labor |
Cheese | 1 labor | 1/2 labor |
Labor | 100 | 100 |
PW/PC | greater than 1 | less than 2 |
PC/PW | less than 1 | greater than 1/2 |
cheese | wine | |
Portugal | 1 wine | 1 cheese |
England | 1/2 wine | 2 cheese |
Production Possibility Frontier:
In autarky, the relative price is the opportunity cost of production.
In Portugal, the relative price of wine is 1 and the relative price of cheese is 1.
In England, the relative price of wine is 2 cheese and the relative price of cheese is 1/2 wine.
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