Question

Consider a Ricardian model. There are two countries called Australia and New Zealand and two goods called beer and cheese. In Australia the unit labour requirement for a beer is 6 hours and for a cheese is 12 hours. In New Zealand the unit labour requirement for a beer is 4 hours and for a cheese is 1 hour. Australia has an endowment of 3600 hours of labour. New Zealand has an endowment of 400 hours of labour.

1. Draw a production possibility frontier (PPF) diagram for Australia and a PPF diagram for New Zealand (separate diagrams please). Cheese must be on the vertical axis and beer must be on the horizontal axis.

2. For both countries state the opportunity cost of producing a beer.

3. Suppose now that we have trade between the countries and the world price is 1 cheese for 1 beer. For each country draw in the budget constraint. For each country label the production point on the diagram.

4. Denote the world prices in dollars as PB and PC respectively. Denote the respective quantities of beer and cheese consumed in New Zealand (following,trade, of course) as DB and DC . Using this notation, write out the budget constraint for New Zealand. Rearrange this budget constraint so that it is clear that the ratio of these world prices is reflected by the slope of the budget constraint. [ DC should be on the left hand side and the rest of the stuff should be on the right hand side.]

5. While the ratio of prices is apparent from Question 3, we will assume from here on that the price of beer is $1 and the price of cheese is $1. If 300 beers are consumed in New Zealand, how many cheeses will be consumed in New Zealand? Now if only 200 beers are consumed, how many more cheeses will be consumed?

6. For both countries calculate the hourly wage rate (with international trade).

Answer 1

	Beer	Cheese	Total endowment
Australia	6	12	3600
New Zealand	4	1	400

Australia can produce either 3600/6= 600 units of beer or 3600/12 = 300 units of cheese. Similarly, New Zealand can produce either 400/4 = 100 units of beer or 400/1 = 400 units of cheese.

So PPF are

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The opportunity cost of producing Beer in Australia = 300/600 = 0.5 cheese

The opportunity cost of producing Beer in New Zealand = 400/100 = 4 cheese

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world Price

1 cheese = 1 Beer

PC=PB

PC=PB= $1

The opportunity cost of producing beer is less in Australia [0.5<4]. Therefore, Australia will produce beer and New Zealand will produce cheese.

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Budget Constraint for Australia

PB*DB + PC*DC = M

DB + DC = M

For New Zealand

Pb*Db + Pc*Dc = M

DC = M/PC - (PB*DB)/PC

DC= M - DB