Question

The world economy consists of two countries, H (Home) and F (Foreign). Both countries use labor to produce bread and fruits. The following table describes the sectoral productivity. country H country F | Absolute Advantage 1.5 kg of bread produced per worker per day kg of fruits produced per worker per day comparative advantage 1 3 / 3 ? Suppose that workers in each country prefer to consume equal amount of bread and fruits. Perfect competition prevails in the product markets and in the labor market. There are 120 workers in country H.

(a) In which product does country H have the absolute advantage over country F? According

to Smith’s theory, which product should country H export? In which product does

country H have the comparative advantage over country F? According to Ricardo’s theory,

which product should country H export?

(b) Specify the production possibility curve (PPC) in country H. Calculate the production

and consumption allocation of country H in the no-trade case. Take fruits as the unit of account.

How much is the relative price of bread in terms of fruits in country H? Use the PPC and the

optimal consumption path to show your results graphically.

(c) Suppose that the population size of country H is substantially smaller than that of country

F. If both products can be freely trade between the two countries, country H is a small

open economy and takes the world price as given. How does free trade with country F affect

the relative price and the production in country H? Calculate the production allocation and the

consumption allocation of country H in the case of free trade. Use the PPC, the balanced trade

line, and the optimal consumption path to show your results graphically.

(d) Instead of relying on free trade, country H can raise its autarkic level of consumption

by improving its productivity in both sectors in equal proportions. By what percentage should

country H improve its sectoral productivity so as to reach the same consumption level as in

question (c)?

(e) Suppose that the population size of country H is similar as that of country F. In the

case of free trade, the world relative price is the average of the autarkic prices in the two

countries. Calculate the production and the consumption allocations in the case of free trade.

Use the PPC, the balanced trade line, and the optimal consumption path to show your results

graphically. Compare with your answer in question (c), how does the country size affect the

size of gains from trade and why?

Answer 1

a) Country H has absolute advantage in the product of fruits over country F.

Country H should export product fruit.

Coutry H has comparative asvantage in the product of bread ove country F.

According to Riccardo, country H should export product bread.

Relative price of bread= 2/1.5 =1.33