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Honours International Economics

Session 1 Sample Questions


Comparative Advantage and the Ricardian Model

Problem 1

Unit of labour requirement (hours) Total Units of Labour


Apples Bananas Available
HOME 3 2 1200
FOREIGN 5 1 800

a. Draw the production possibility frontier for Home and Foreign.

b. In the Home country: What is the opportunity cost of apples in terms of bananas? In the
absence of trade, what would the price of apples in terms of banana be? Why?

In the home country, the opportunity cost of apples in terms of bananas is 1.5: to produce one
more unit of apples 3 units of labour are needed and these can only be obtained by reducing
the production of bananas by 1.5 units. Similarly, the opportunity cost of apples in terms of
bananas in the foreign country is 5. In the absence of trade, the relative prices must reflect
the local opportunity costs. Hence the relative price of apples would be 1.5 at home and 5 in
the foreign country.

c. Construct the world relative supply

For pb/pa ≤ 1/5, both countries specialise in the production of apples. For pb/pa = 1/5, the
home country specialises in the production of apples while the foreign country is indifferent
between producing any combinations of apples and bananas on its PPF. Hence Qb/Qa ranges
from 0 to 800/400 = 2. For 1/5 < pb/pa < 2/3, foreign specialises in the production of
bananas and home in the production of apples. Hence Qb/Qa = 800/400 = 2. For pb/pa = 2/3,
foreign only produces bananas, while home is indifferent between any combinations on its
PPF. Hence Qb/Qa varies between 2 and infinity.

d. Assume that the world relative demand takes the following form:

demand for apples/demand for bananas = price of banana/price of apples

- Graph the relative demand curve along the relative supply curve
- What is the equilibrium relative price of apples?
- Describe the pattern of trade and show that both Home and Foreign gain from trade.

Da/Db = pb/pa or Db/Da = pa/pb. So, at Db/Da = 2, pb/pa = ½. Hence, as seen on the gra[ph
below, relative supply and relative demand intersect for a relative price of pb/pa = ½. This is
the range of price for which each country is completely specialised according to its
comparative advantage, i.e. home produces 400 units of apples and foreign produces 800
units of bananas. Since each country faces free trade prices that differ from its relative
autarky prices, each country gains from trade, as shown on the next graph.
Problem 2

WINE CHEESE
ENGLAND 5 5
PORTUGAL 1 4

Each country has 100 units of labour available.

Assume that consumer preferences in both country are now given by:

U = CwCc

Where Ci is the quantity of good i consumed. With such preferences we know that consumers
spend exactly half of their income on wine and the other half on cheese.

Determine the quantities produced and consumed, the levels of import and export for each
country as well as the relative price of the two goods under free trade.

We begin by drawing the world PPF:

We must now determine where the world PPF is tangent to the highest possible indifference
curve. A natural place to start is the kink of the world PPF. The tangency will occur at this
kink if the slope of the indifference curve at this kink lies strictly between the slopes of the two
pieces of the world PPF joining at the kink. These two slopes are 1 on the left-hand side and
4 on the right-hand side.
For the preferences given we know that pwCw = pcCc, i.e. that pc/pw = Cw/Cc, which means
that the slope of the indifference curve is given by Cw/Cc. At the kink, this is equal to 100/20
= 5, which is bigger than 4. Hence we do NOT have tangency at the kink. Instead, tangency
occurs on the steeper part of the world PPF, as drawn on the graph.

At this point E, the relative price of C with respect to W is equal to the slope of the
Portuguese PPF, i.e. 4. So let us say that pw = 1 and pc = 4. We also know that England
completely specialises in the production of cloth. Hence QcE = 20 and QwE = 0. Now we turn
to consumption. England’s budget constraint is pcQcE + pwQwE = pcCcE + pwCwE. Since QcE =
20, QwE = 0 and we know that pcCcE = pwCwE, we get 20pc = 2pcCcE. But we also know that pw
= 1 and pc = 4, therefore 80 = 8CcE and CcE = 10. Therefore CwE = (pc/pw)CcE = 40. Hence
England exports 10 units of cloth and imports 40 units of wine.

We must now determine the total world production of both C and W, i.e. we must determine
the coordinates of point E. We know two things about this point. Firstly it is on a line of slope
-4 going through point (45,0). The equation of this line is W = -4(C – 45). Secondly, we
know that the slope of the indifference curve at this point is also equal to 4 in absolute value,
i.e. W/C = 4. Combining the two equations, we get C = 180/8 = 22.5 and W = 90. Hence
Portugal produces 22.5 – 20 = 2.5 units of cloth and 90 units of wine. Since Portugal imports
10 units of cloth (as England exports 10 units) it consumes 10 + 2.5 = 12.5 units of cloth.
Similarly, as Portugal exports 40 units of wine it consumes 90 – 40 = 50 units of wine.

Problem 3

Assume that Home and Foreign are both able to produce and consume the following four
goods in autarky according to the unit labour requirements provided below.
Good Home Unit Labour Foreign Unit Labour
Requirement Requirement
A 1 12
B 2 18
C 4 24
D 15 30

a. In which good does Home have the greatest relative productivity advantage? In which
good does Home have the lowest productivity advantage?.

Home has the greatest comparative advantage in the good for which the ratio between its unit
labour requirement and Foreign’s unit labour requirement is lowest. This is good A, with a
ratio of 1/12. The good in which home has the lowest relative productivity advantage is good
D with a ratio 0f 15/30 = ½. Equivalently, we could say that labour productivity is measured
as one over the unit labour requirement and compute the productivity ratios directly.

b. If the Home wage rate is 8 times the Foreign wage rate, what goods will be produced by
Home? What goods will be produced by Foreign?

Perfect competition implies that the price of a good is equal to its labour cost.International
trade implies that the price of a given good is the same everywhere. Hence the home country
will produce a good only if its labour cost per unit is not higher than the foreign labour cost
per unit. Since the Home wage if 8 times large than the foreign wage, a good can only be
produced at home if Home’s productivity for this good is at least 8 times larger than
Foreign’s productivity for the same good. This means that Home will produce goods A and B
(productivity rations of 12 ans 9 respectively) but not C and D (productivity ratios of 6 and 2,
respectively).

c. Show how this pattern of specialisation and trade change if the relative wage were
w/w*=6? What would be the new pattern?

Following the same logic as above, Home still produces A and B but now good C can be
produced by both countries. Good D is still only produced in Foreign.

d. Show how this pattern of specialisation and hence trade is beneficial to each country?

See lecture notes.

e. Discuss the reasons why, in practice, specialisation is not as extreme as suggested by your
response to part b.

See lecture notes: transportation costs, product differentiation etc….

Problem 4

In a Ricardian model with two countries and two goods, draw a diagram which relates wages
at home relative to wages abroad (i.e. w/w*) on the vertical axis to the world terms of trade
(P1/P2) on the horizontal axis. Do changes in the terms of trade brought about by shifts in
world demand always bring about changes in w/w*? In the same proportion?

Assume that country A has a comparative advantage in good 1 and country B has a
comparative advantage in good 2. This means that a1*/a1 > a2*/a2, where ai is good i’s unit
labour requirement at home(country A) and ai* is good i ‘s unit labour requirement abroad
(country B). Further, we know that the slope of the PPF in country A is a1/a2 and the slope of
the PPF abroad is a1*/a2*. If P1/P2 < a1/a2 then both countries specialise in the production
of good 2 and wa2 = P2 = w*a2* so w/w* = a2*/a2. If P1/P2 = a1/a2 then B specialises in good
2 while A can produce both goods. Since the previous equations still hold, we still have
w/w*= a2*/a2. Now assume that a1/a2 < P1/P2 < a1*/a2*. Each country specialises according
to its comparative advantage. Hence P1 =w a1 and P2 = w*a2*. So, w/w* = (P1/P2)(a2*/a1), a
straight line of slope a2*/a1 and going through the origin. Finally, for P1/P2 ≥ a1*/a2*, both
countries can produce good 1 so that wa1 = P1 = w*a1*. Hence w/w* = a1*/a1.

A change n terms of trades resulting from a shift in demand does not necessarily change
w/w*. Any change that would still leave the intersection between demand and supply on the
same flat part of the supply curve would leave w/w* unchanged. For a change in P1/P2 to be
reflected as a proportional change in w/w*, both the initial equilibrium and the equilibrium
after the demand shift must occur on the upward sloping part of the supply schedule.

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