Question

Consider a two countries, Portugal and England, that produce two goods, wine and cheese, with only...

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
1. Which country has a an absolute advantage in wine? In cheese? Which country has a comparative advantage in wine? In cheese?
2. Draw the Production Possibilities Frontier for each country.

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).

1. Describe the autarky equilibrium in each country. (Represent graphically if you wish.)

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!)

1. Suppose the two countries are allowed to trade. What will be the range of relative prices of wine for which there will be trade? What will be the range of relative price of cheese for which there will be trade?

(Note that when you read “relative price of cheese” this is means “price of cheese relative to wine” or PC/PW and vice versa)

1. Suppose the world relative price of wine is 1.5
1. Will the countries trade? If so, describe the pattern of trade.
2. At this price, exactly how much wine and cheese will Portugal produce? In particular, what can you tell me about specialization?
3. Explain the gains from trade.
2. Suppose the world relative price of wine is 1.7. What changes with respect to question 6? More specifically:

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.

1. Suppose the amount of labor in Portugal grew to 120. How would the PPF in Portugal change? Would Portugal’s comparative advantage change? Would the range of prices for which trade occurs change?
2. Suppose now the world relative price of wine is 2. Will there still be trade? Why or why not? (HINT: Once again, look at the gains from trade)
3. Suppose now the world relative price of wine is 3. Will there still be trade? Why or why not? (HINT: Once again, look at the gains from trade)

 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
• Absolute advantage in wine: No country
• Absolute advantage in cheese: England
• Comparative advantage in wine: Portugal
• Comparative advantage in cheese: England
 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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