Question

Determine whether each of the following statements is TRUE or FALSE. Justify all the answers in few sentences 1. (6 points) In the general neoclassical model with perfect competition, constant returns to scale, homothetic preferences. (a) The consumption bundle under autarky may not be affordable under free trade (b)Let p be the price vector under autarky, p be the price vector under trade, and m be the vector of net imports under trade. Thern , (p* -pP)o (c) With 2 goods and 2 countries, a country is worse off when the relative price of imports increases 2. (8 points) In the Ricardian model with 2 goods (Wine and Cheese) and 2 countries (Home and Foreign) and (except otherwise noted) identical preferences between countries: (a) If both countries have the same number of workers and Home has a higher wage, then Home must be more productive in both goods. (b) The Home country is never made worse off by productivity growth at Foreign (c) Under free trade, if both countries are incompletely specialized then an increase in the number of workers at Home increases the utility of each worker in Foreign. (d) Suppose that people at Home only eat cheese while people at Foreign only drink wine. Then, if both countries trade in positive quantities, the price of wine in terms of cheese at home must be cheaper under autarky than under trade.

Answer 1

Answer 1

a) False

The neo classical theory of free trade envisions gains from free trade that makes both the parties engaging in free trade, gain from the transaction. It implies that all the bundles previously available under autarky will also be available but free trade provides an opportunity to go on higher indifference curves and achieve bundles of goods that were previously not available. It assumes a vector wise increase in commodity bundles and hence all autarky bundles have to be available for a vector wise increase in consumption.

b) False

The value of (p^A - p^F)m^F will depend on value of p^A and p^F respectively, i.e. if price vector is greater in autarky or in free trade. The free trade price is normally between the two autarky prices of two trading countries. However, if one country is very large, then the free trade price may reduce to the autarky price of the large country. In that case the value of (p^A - p^F)m^F will not necessarily be less than equal to zero.

c) True

The terms of trade (TOT) is the ratio of export prices to import prices. When import prices increase the TOT falls and a country becomes worse off. This reduces the ability of import for a country and can also reduce standard of living. However for this to hold, it is necessary that the prices of exports remain unchanged. TOT generally worsens after depreciation or devaluation of a currency.