Question

Consider a world with two countries, Home and Foreign, both able to produce two goods: cloth and tablet computers. The production of both goods uses
capital and labor in fixed proportions, with the tablets industry using more capital per worker than the cloth industry. The units of each input needed to produce one unit output are given by:

	capital	Labor
Cloth	1	2
Tablets	2	1

Both countries have 150 units of capital available for production, but the Home country has 100 units of
labor whereas the Foreign country has 200. Consumers like to consume both goods and have the same
preferences in both countries. Assume that the countries are closed to international trade.

a) Construct the PPF for both countries and put them in the same graph. Show in the graph the quantity
of both cloth and tablets that are produced by each country in equilibrium, if the countries are not
trading. [HINT: assume regular indifference curves and use the graph to determine the quantity of
each good demanded at the highest indifference curve.] Compute these quantities algebraically.

b) Which country produces more cloth relative to tablets? Indicate how this feature relates to the
country’s relative factor endowments.

c) Compute the quantities of labor and capital employed in each country in the production of each of
the goods at the output levels in a).

d) Indicate the range of prices of cloth relative to tablets at which the Home country will produce both
goods. Which good would be produced if the relative price was outside of this range?

e) In which country will the price of cloth relative to tablets be higher? Explain.

f) Assume that both countries open to trade with each other. Explain how the price of cloth relative to
trade will change in each country after opening to trade.

g) According to the Heckscher-Ohlin theorem, if these two countries opened to trade, which country
would export which good? Explain.

h) Give intuition about who will be better off and who will be worse off in each country after opening
to trade. Explain.

Answer 1

Based on the given information

The production possibility of both countries are as follows

Capital Home 150 Labor 100 Left Cap Capital C Labor C Cloths Left Lab Labor T Tablet Total Cap Total Lab Total Production Capital T 0 0 C 150 100 150 100 75 150 100 75 10 20 10 140 80 140 80 70 150 100 80 17 34 17 133 66 133 66 66 150 100 83 20 40 20 130 60 130 60 60 150 100 80 40 40 40 70 30 60 30 120 120 150 100 40 80 40 110 20 110 20 20 150 100 60 50 50 100 100 0 100 150 100 50 R 88 8 °

Away Capital 150 Labor 200 Capital C Labor C Left Cap Cloths Left Lab Labor T Tablet Total Cap Total Lab Total Production Capital T 0 0 0 150 200 150 200 75 150 200 75 10 20 10 140 180 140 180 70 150 200 80 20 40 20 130 160 130 160 65 150 200 85 30 60 30 120 140 120 140 60 150 200 90 40 80 40 110 120 110 120 55 150 200 95 50 100 50 100 100 100 100 50 150 200 100 60 120 60 90 80 90 80 45 150 200 105 70 140 70 80 60 80 60 40 150 200 110 40 40 80 160 80 70 70 35 150 200 115 82 164 82 68 36 68 36 34 150 200 116 84 168 84 66 32 66 32 32 150 200 116 90 180 90 60 20 60 20 20 150 200 110 100 200 100 50 0 50 150 200 100

The production possibility frontier can be created using following information

For Home Country

Tablet Cloths 75 70 66 60 0 10 17 20 30 40 20 40 50 R

For Away Country

Cloths Tablet 75 70 10 65 20 60 30 55 40 50 50 45 60 40 70 80 35 82 34 84 32 20 90 100

a)

PPF 80 70 60 50 40 Away 30 Home 20 10 0 20 40 60 80 100 120 Cloths Tablet

b)

As given in the question that the consumer like to consider both the goods in both countries. So both the goods has equal demand of equal WTP. In this case the country will benefit by producing a combination which will result in a higher highest total output. i.e. sum of both products should be maximum

In the case from the table above we can see that the maximum production by home country is 8 which is produced by combination of 17 cloths and 66 tablets. Thus, home country will produce more tablets than cloths.

The maximum production by away country is 116 which is produced by combination of 82 cloths and 34 tablets or 84 cloths and 32 tablets. Thus, home country will produce more cloths than tablets.

c) From table we can see that both countries use total capital and labor assigned to them

i.e. for home country

Capital = 150 and Labor =100

For away country

Capital = 150 and Labor =200

d) We considered both are equally important and thus price of both of them must be equal. Assuming tablets has a price of 1 unit. And price of Cloth is x unit

Then the country will produce only cloths if

50x > 17x + 66

x > 2

and will produce only tablets if

75 > 17x + 66

x < 0.53

Hence, the price of cloth should be more than 53% of price of tablet and less than 200% of price of cloth