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Practice Set 1 Detailed Answer Key (prepared by Andre Castillo. Please go to his office hours with any questions regarding the detailed answer key) 1) Rugs Peru Guatemala 5 10 Coffee 15 5

a) Peru has absolute advantage in rugs (5 < 10) and Guatemala has absolute advantage in coffee (5 < 15) b) The opportunity cost for Peru of rugs is 5/15 = 1/3 coffee. The opportunity cost of rugs for Guatemala is 10/5 = 2 coffee. c) Guatemala should specialize in coffee because it costs it less rugs than it does Peru (.5 rugs for Guatemala v. 3 rugs for Peru, the inverses). Another way to look at it is that it costs Peru relatively less to produce rugs (1/3) and should therefore specialize in rugs, and Guatemala by definition should specialize in the opposite. d) Prices must fall between their opportunity costs to be mutually beneficial, which here is 1/3 < Price of rugs/ Price of coffee < 2, or conversely < Price of coffee/price of rugs < 3. 2) a) In autarky the price ratios are the opportunity costs. Opp. Cost France, computers in terms of wheat: 100/4 = 25W. Pc/Pw = 25 Opp. Cost Germany, computers in terms of what: 60/3 = 20W. Pc/Pw = 20 b) The country with the lower opportunity cost has the comparative advantage. Here, for computers, it is Germany. For wheat it is France (1/25 < 1/20). c) First, ask how many wheats is France paying without trade. Currently it is 25 wheats for one C. With trade, if Pc/Pw = 22, then France is now using 22 wheats for one C. It saves 3 wheats. Since one wheat costs 4 days of labor, France saves 3*4 = 12 days of labor.

Germany on the other hand is saving computers per wheat it imports since it specializes in making computers. Now the price of W is 1/22 C, which in terms of days of labor is equal to 60/22 days = 2.73 days. Before the price was 1/20 C, which is equal to 60/20 days = 3 days. Germany saves 3-2.73 = 0.27 days/wheat import. d) If Pc/Pw = 24, then France saves only 1 W from its autarky cost of producing 1 C. 1 W is worth 4 days of labor in France. If Pc/Pw = 24, then Pw/Pc = 1/24. Germany now pays only 1/24 C for one W, which is equal to 60/24 = 2.5 days of labor. In autarky it was 3 days of labor, so Germany is now saving .5 days/wheat import. e) As the international terms of trade move closer to those of France in autarky, the benefits accruing to Germany increase (e.g., a saving of 0.5 days/wheat instead of 0.28 days), and the benefits accruing to France decrease (e.g., a saving of only 4 days/computer instead of 12 days). 3. a) The chart tells us the unit labor requirement to produce one textile and one auto in the UK and US. Here it is days of labor. In the UK, the unit labor requirement is 3 days. That is, 3 days of labor will produce one textile. This means that one day of labor will produce 1/3 of a textile. Algebraically that looks like this: UK: # of Textiles = Days of Labor used for Textiles / 3 1 day of labor = 1/3 Textile Likewise, one day of labor will produce just 1/6 of an Auto. UK: # of Autos = Days of Labor used for Autos / 6 1 day of labor = 1/6 Auto Similarly, if the U.S. were to use one day of labor to produce Textiles and one day of labor to produce Autos, it would get: US: 1 day of labor = Textile 1 day of labor = 1/5 Auto b) The Production Possibility Frontier (PPF) is line or curve which represents every possible combination of goods the country can produce given its constraints. Here the constraint

is 1000 days of labor. Since we assume there are no diminishing returns to labor, the line is straight. To draw a straight line we just need to find the x and y-intercepts and connect them. Here, the x and y-intercepts will be the labor endowment (1000 days) / unit labor requirement. These points represent the most Textiles and Autos the US can possibly produce given its constraint of 1000 days of labor. US, Textiles: 1000 / 2 = 500 US, Autos: 1000 / 5 = 200

c) Absolute advantage means who can produce the good the most efficiently. To do this we just compare the unit labor requirements (aL). aLt (US) = 2 aLt (UK) = 3 The US requires less labor to produce the same amount of Textiles, so it has an absolute advantage in producing Textiles. Likewise for Autos, the aLa (US) is only 5 while the aLa (UK) is 6, so the US also has an absolute advantage in producing Autos. d) Having a comparative advantage means having a lower opportunity cost, which is by definition relative. To find opportunity cost of x we divide aLx/aLy. So, the opportunity cost of the US to produce 1 Textile is: Opp. Cost of 1 Textile, US: 2/5 Autos

By producing 1 Textile, the US is forgoing 2/5 of an Auto. For the UK, meanwhile: Opp. Cost of 1 Textile, UK: 3/6 Auto (or Auto) By producing 1 Textile, the UK is forgoing of an Auto. > 2/5, so the US production of Textiles has a lower opportunity cost than the UKs production of Textiles. The US therefore has a comparative advantage in Textiles. By definition, the UK then has a comparative advantage in production of Autos. Opp. Cost of 1 Auto, UK: 6/3 Textiles (or 2 Textiles) Opp. Cost of 1 Auto, US: 5/2 Textiles (or 2.5 Textiles) e) Pa/Pt is 2. Flip this to Pt/Pa = to see how it compares to the US good that it has a comparative advantage in. If the price is greater than that, the US will gain from trade. Pt/Pa is > than Opp.Cost US textiles, which is 2/5 (or .4). So the US can now produce only textiles at a cost of .4 and now earn .5 for each one it produces. So, 500 * .5 = 250, which is the new point on the US CPF.

4. Part a. Question 1: Home has 1200 units of labor available. It can produce two goods, apples and bananas. The unit labor requirement in apple production is 3, while in banana production it is 2. a) Graph Homes production possibility frontier.

First, we have to find the x and y intercepts. Again, this is done via the following: L / aLx and L / aLy. L is 1200, aLa (unit labor requirement for our x-axis, apples) is 3, and aLb (unit labor requirement for our y-axis, bananas) is 2. That looks like this: Bananas
600

The x-intercept is 1200/3 = 400 The y-intercept is 1200/2 = 600

400

Apples

b) What is the opportunity cost of apples in terms of bananas? The opportunity cost of apples in terms of bananas is aLa/aLb. Opp. Cost apples: 3/2 bananas c) In the absence of trade, what would the price of apples in terms of bananas be? Why? In the absence of trade, price is determined by opportunity cost. So, the price of apples in terms of bananas, Pa/Pb, is 3/2. This goes back the assumptions we made at the beginning of the model regarding labor mobility and perfect competition. As Senses says:

Question 2: Home is as described in problem 1. There is now also another country, Foreign, with a labor force of 800. Foreigns unit labor requirement in apple production is 5, while in banana production it is 1. a) Graph Foreigns production possibility frontier. With 800 units of labor, Foreign can produce 160 apples at most (L/aLa, our x-intercept) or at most 800 bananas (L/aLb). That looks like this: Bananas
800

100

Apples

b) Construct the world relative supply curve. To derive the world relative supply curve, we have to figure out when each country will decide to produce a good. We know from lecture that the graph will have four points (1) vertical, (2) horizontal, (3) vertical, and (4) horizontal again, like a step ladder. Go ahead and draw it now:
Apples + Apples* Bananas + Bananas* P-apples P-bananas

The quick and easy way do this is to first plot the two points on the y-axis and then the one on the x-axis. The y points are the opportunity costs for each country, Home and Foreign. Homes is 3/2, and Foreigns is 5/1.
x Apples + Apples* Bananas + Bananas* Pa/Pb

3/2

X is the relative world supply when the world relative price is between 3/2 and 5. So, using that information, lets solve for X: Apples + Apples* = Bananas + Bananas* X

Lets pick a price between 3/2 and 5, like 3. When the price of apples is 3, Home wants to produce apples (Pa/Pb > cost of apples). Foreign, however, does not. (Pa/Pb < cost of apples). So, Home will produce only apples and Foreign only bananas. Knowing that, we just plug in the information we had from before: (400) + (0)* (0) + (800)* = X = 1/2

Now we can finish the graph.

3/2 Apples + Apples* 1/2 2 Bananas + Bananas*

Part b. Home now has 2400 units of labor. The only point affected by this on our relative supply curve is the x-point. Home still produces apples and Foreign still produces bananas, but the amount of apples that Home will produce has doubled, since their labor endowment has doubled. (800) + (0)* (0) + (800) = X = 1/1

Part c. Home still has 2400 units of L, but they are now half as productive. This means that it will take Home twice as many labor units to produce the same amount of apples and bananas. Maybe the country just legalized pot, I dont know. Anyway, aLa is now 6 and aLb is now 4. The opportunity cost is the same: 3/2. This means our y-points will stay the same. Our X-point will change again, however. Foreign hasnt changed, but Home will now produce L / aLa, which is 2400 / 6 = 400. (400) + (0)* (0) + (800)* = X =

d) 3-5 from K & O p. 52 (8th) 3. Now suppose world relative demand takes the following form: demand for apples/demand for bananas = price of bananas/price of apples a. Graph the relative demand curve along with the relative supply curve Plug in to find the point of intersection. (1/2) = Pb/Pa Now invert to fit the number into our graph. Pa/Pb = 2 Demand curve crosses the point where Pa/Pb = 2. Other points on the curve (not shown in the graph per se) are (1/5, 5), (1, 1), (2, ), etc.

b. What is the equilibrium relative price of apples? Since it crosses the supply curve there, the equilibrium price is 2. Note that the demand curve does not have to cross the supply curve at this point. c. Describe the pattern of trade Each country will produce the good they have a comparative advantage in home apples, foreign bananas and each country will trade some of those goods for the good that the other is producing. d. Show that both home and foreign gain from trade In the absence of trade, Home could gain three bananas by foregoing two apples, and Foreign could gain by one apple foregoing five bananas. Trade allows each country to trade two bananas for one apple. Home could then gain four bananas by foregoing two apples while Foreign could gain one apple by foregoing only two bananas. Each country is better off with trade. 4. Suppose that instead of 1200 workers, home had 2400. Find the equilibrium relative price. What can you say about the efficiency of world production and the division of the gains from trade between home and foreign in this case? The increase in the number of workers at Home shifts out the relative supply schedule such that the corner points are at (1, 3/2) and (1, 5) instead of (1/2, 3/2) and (1/2, 5). Qa + Qa* / Qb + Qb* = 1 The intersection of the relative demand and relative supply curves is now in the

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lower horizontal section, at the point (2/3, 3/2). In this case, Foreign still gains from trade but the opportunity cost of bananas in terms of apples for Home is the same whether or not there is trade, so Home neither gains nor loses from trade.
RD RS 2 RS

1/2

5. suppose that Home has 2400 workers, but they are only half as productive in both industries as we have been assuming. Construct the world relative supply curve and determine the equilibrium relative price. How do the gains from trade compare with those in the case described in problem 4? This answer is identical to that in 3. The amount of effective labor has not changed since the doubling of the labor force is accompanied by a halving of the productivity of labor.