Question

3. a. Use a PPF and a community indifference curve to show a country initially exporting food and importing clothing. On your diagram, show production, consumption, imports, exports and welfare, and indicate the relative price clothing.

b. On the same diagram, show how immiserizing growth is possible. Include the new points of production and consumption as well as imports, exports, welfare and the new relative price of clothing. Explain fully.

Answer 1

a.

Production Possibility Frontier or Production Possibility Curve shows combination of goods which an economy can produce using its available resources.

PPF of Home and Foreign Country Without Trade

In home country, production of 1 unit of food requires 3 labors and there is only 60 labors in the country. So, home country will able to produce 20 units of food if it use all its labor in the production of Food. Similarly, when economy uses all its labor in the production of cloths then, it is able to produce 12 units of clothing i.e. (60/5). In Foreign country, production of 1 unit of food requires 9 labor and there exist only 90 units of labor so it can produce 10 units of food if it employ all its labor in the production of food. On the other hand, it can produce 30 units of cloth if it employ all 90 units of labor in the production of clothing. This implies production possibility frontier of countries will be:

The above diagram shows the PPF curves of Home and Foreign country. X-axis shows production of cloth and Y-axis shows production of food by both home and foreign country in different diagram. Since, home country can produce maximum 12 units of cloth by using all its available resources so, PPF touches 12 units on X-axis and vice-versa. By combining the combinations which economy can produce with available resources results in the formation of PPF.

PPF of Home Country PPF of Foreign Country Quantity of Food Quantity of Food 20 10 PPF 12 Quantity of Cloth PPF 30 0 0 Quantity of Cloth

World PPF Under Trade

When different countries trade with each other then, each country produce that good in which it has comparative advantage. A country has comparative advantage in producing a good if opportunity cost of producing that good is lower in that country as compare to other country. Opportunity cost is defined as the number of unit of food an economy would have to give up in order to produce an extra unit of cloth or vice-versa.

Since, Home country has comparative advantage in the production of Food and Foreign country has comparative advantage in the producion of cloth so, home and foreign country will produce food and cloth respectively. Due to this economy is able to increase its overall production of goods. The PPF after trade will be:

World PPF After Trade Quantity of Food 20 PPF 30 0 Quantity of Cloth

Opportunity cost of Home country in the production of Food:

Home country can produce 1 unit of food by employing 3 labors while it can produce 1 unit of cloth by 5 labors. So, opportunity cost in the production of food will be 0.6 units i.e. (3/5) as home country has to sacrifice 0.6 units of clothing to produce an additional unit of food.

Opportunity cost of Foreign country in the production of Food:

Foreign country can produce 1 unit of food by employing 9 labors while it can produce 1 unit of cloth by 3 labors. It shows that foreign country requires 3 times labor in the production of food as compared with clothing. So, opportunity cost in the production of food will be 3 units i.e. (9/3) as to produce 1 more unit of food, foreign country has to sacrifice 3 units of clothing.

If the price of clothing is 1 then, the price of food under autarky in each country will be calculated by taking the given situation where ratio of prices of cloths and food is equal to the ratio of unit labor requirement in the production of cloth and food respectively i.e.

$\frac{P_{c}}{P_{f}}=\frac{a_{Lc}}{a_{Lf}}$

Price of food in home country before trade will be:

$\frac{1}{P_{f}}=\frac{5}{3}$

Implies, P_f = 3/5 = 0.6

Price of food in foreign country before trade will be:

$\frac{1}{P_{f}}=\frac{3}{9}$

Implies, P_f = 9/3 = 3

Price of Food after trade will be:

$\frac{1}{P_{f}}=\frac{3}{3}$

Implies, P_f = 1

(b) Wage rate is equal to the value of marginal product.

After trade, economy is able to produce 20 units of food and 30 units of cloth. So, to calculate wage rate in Home country to produce food will be :

W_F = VMP

W_F = P_F X MP = P_F X 1/a_LF

W_F =  P_F/a_LF = 1/3 = 0.33

Similarly,

W_C = P_C/a_LC = 1/3 = 0.33

It shows that wage in both countries for the production of cloth and food is same.

International trade is mutually beneficial for home and foreign country due to following reasons :

1. It enables a country to consume outside production possibility frontier. In the absence of trade, consumption possibilities are same as production possibilities. But after trade, country can produce different combination of good and consume different combination of good.

2. Gains from trade arises due to indirect method of production. Home country can produce both goods but it specialises in that line of production in which it has comparative advantage. Labor has its opportunity cost so home country uses an hour to produce 1/a_LF unit of food and trade it in exchange for cloth at P_F/P_C.