Week 2 (7)
Trade and Comparative Advantage
Assume there are just two countries in the world, i.e. the European Union (EU) and the Rest of the World (RW). Both countries produce and consume 2 products: bicycles (b) and apples (a). Per bike, the EU puts in 3 hours of labour while the RW puts in 5. Per ton of apples, the EU needs 2 hours v. the RW 1 hour of labour. A further given is that the EU has 2400 hours of labour available v. RW 1600. The world relative demand has the following form: demand for bikes/demand for apples = price of apples/price of bikes. Please answer the following questions:
a. How high are the opportunity costs of a bike in the EU and the RW in the absence of international trade? Also give the opportunity costs of a ton of apples in both countries. Which product will the EU be exporting?
Required hours of labour per product unit
| |Bicycles (unit) |Apples (ton) | |EU (2400) |3 (800) |2 (1200) | |RW (1600) |5 (320) |1 (1600) |
EU opportunity cost of bike (per unit) in terms of apples (in tons): 3/2 or 1.5
Opportunity cost of apples (in tons) in terms of bike unit: 2/3 RW opportunity cost of bike (per unit) in terms of apples (in tons): 5/1 or 5 Opportunity cost of apples (in tons) in terms of bike unit: 1/5 or 0.2
The EU will be exporting bicycles, because they possess a comparative advantage.
b. Draw the production possibility frontier for the EU.
L/a LB = 800
L/a LA = 1200
Slope: price B/A
c. What is the relative price of a bike in the EU in the absence of international trade?
The relative price of a bicycle in the EU would be the equal to the opportunity cost in this case which is 1.5 tons of apple.
d. Now assume that in case of free international trade, the world relative price of bikes is 2. Use the equilibrium price to demonstrate that the EU will benefit from international trade.
Units of product produced if both countries specialize in c.a. product for trade | |Bicycles |Apples | |EU (2400) |800 |0 | |RW (1600) |0 |1600 |
Before trade the price of bikes in the EU was 1.5; know with trade the relative price of bikes is 2 so the EU does benefit (0.5).
In the table below, the required labour per product unit has been rendered for a Ricardian world with two countries (Home and Foreign) and two products (cloth and steel). In autarky both countries produce both products. In case of free international trade the relative price of cloth (Pc/Ps) is 1. Home has 1000 units of labour at its disposal. Foreign has 5000 units of labour.
Required units of labour per product unit. | | | |Opportunity costs |Opportunity costs | | |Cloth |Steel |cloth |steel | |Home  |10 (100) |5 (250) |10/5 = 2 |5/10 = ½ | |Foreign  |50  (100) |50  (100)...
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