QUESTION
Exercise 1
1. Two countries, Home and Foreign, both produce cheese and wine. The number of hours it takes for the countries to produce one unit of either good is presented in the table below
Home country Foreign country
a cheese 2 hours 3 hours
a wine 3 hours 2 hours
where a cheese and a wine are the unit labour requirements in the production of cheese and wine, respectively. Assume that both countries have the same set of standard homothetic indifference curves (i.e. the same tastes).
1.1. Which country has a comparative advantage in the production of cheese? Which country has a comparative advantage in the production of wine? Explain your answer thoroughly. (1 points)
1.2. Assume both the Home country and the Foreign country have a labour supply of 12 hours each.
Figure 1.2 below depicts the PPFs, and the equilibrium points (A and A*) of the Home country and the Foreign country in autarky. Do both countries maximize their welfare (utility) in autarky? Explain your answer thoroughly. (1 points)
Figure 1.2.
Cheese
6
4
A
A*
4 6 Wine
1.3. Note that point E on Figure 1.3. is the equilibrium consumption point of Home country after trade with the Foreign country. Graphically draw and explain the Consumption Possibility Frontier of the Home country after trade and the indifference curve associated with the highest level of utility that it can reach after trade. Explain your answer thoroughly. (3 points)
Figure 1.3.
Cheese
6
P
4
3 A E
A*
IA
3 4 6 Wine
1.4. Given the information on Figure 1.3. What can you say about the trade patterns? Specifically, what is the world price of cheese after trade? What is the consumption of the Foreign country after trade? Locate and show the consumption point of the Foreign country after trade on the Figure 1.3. What is the value of exports of Home and Foreign countries? Explain why both countries gain from trade! (3 points)
1.5. Can point F on Figure 1.4. be the consumption equilibrium point after trade? Explain your answer thoroughly. (2 points)
Figure 1.4.
Cheese
6
5 F
4
A
A*
3 4 6 Wine
Exercise 2
Presume a Heckscher-Ohlin world and additionally assume that (i) country A is labour
abundant while country B is capital abundant and (ii) the production of cars is capital
intensive while the production of food is labour intensive.
1) Draw an appropriate (2 country, 2 good) graph to represent the two countries in autarky (before trade), their autarkic relative prices, then the world price, production and consumption points of the two countries once they start trading in accordance with the Heckscher-Ohlin theorem. Explain your graph thoroughly. (2 points)
2) Figure 2.1. below presents a “box diagram” of country A. Assume that country A produces 40 units of food and 30 units of machine.
Figure 2.1.
Increasing capital used in machine production
100 60 O Machine
50
Increasing labour F Increasing labour
used in food used in machine
production 40 M 10 production
50
O Food 40 100
Increasing capital used in food production
2.1. Given the information on Figure 2.1., determine the unit labour and capital requirements in the production of food and machine (i.e. aLFood, aKFood, aLMachine and aKMachine). Explain your answer thoroughly. Which good is capital intensive or labour intensive? (2 points)
2.2. State the Rybczinski theorem and use the diagram to illustrate what happens to the production of machines and food when country A’s labour supply increases from 50 units of labour to 75 units of labour while its capital supply and the relative price of food remain unchanged. (3 points)
2.3. Supposing now that both labour and capital supplies of country A increase by 100% (i.e. country A’s labour and capital supplies are now 100 and 200 units, respectively) and suppose that the ratios of labour to capital used in the production of food and machines remain unchanged (i.e. the relative price of food remains unchanged), using the box diagram graphically determine and show the inputs used to produce food and machines of country A following the above-mentioned increase of its labour supply. Do the outputs of both food and machines increase? Explain your answer thoroughly.
(3 points).
SOLUTION
Exercise 1
1.1 The home country has comparative advantage in the production of cheese and the foreign country has the comparative advantage in the production of wine. This is because he home country consume less labor hours for the production of cheese as compared to the foreign country. Since both the countries have same set of indifference curve thus there is no difference in this aspect.
1.2 It cannot be said that in autarky both the countries maximize their wealth as the equilibrium point for both the countries is in the centre of the curve. Thus the number units produced will be less than actually produced in case comparative advantage is taken by both the countries. Since the maximum output for home country is 6 units of cheese so in case it produces cheese and wine, the total output will be less. Thus since both the countries have the same demand for both the products and thus the demand for wine will not be satisfied by home country whereas the foreign country will have excess of wine and he vice versa for cheese.
1.3 The indifference curve of the home country as well as the foreign country will move upward as both countries move towards specialization as more consumption of goods will take place in both the countries.
The diagram shown below clearly shows the shift in slope of the production curve and thus the indifference has moved upward. This clearly shows that both the countries have taken advantage of the specialization and thus have created trade surplus resulting in the advantageous position for both the countries (Leamer, 1985).
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As seen in the above diagram, the dotted line shows the shift in PPF of the home country and the foreign country. This clearly shows the shift in the PPF. Thus with the shift in the PPF due to the comparative advantage has resulted in increased consumption of both wine and cheese. Thus this has been advantageous for both the countries in going in for specialization rather than the Autarky.
1.4 As seen from the graph, both the countries would like to take advantage of the comparative advantage that is at hand. Thus surely these countries have opted for the optimum production of goods by specializing in their respective field. Thus the trade pattern clearly highlights there has been gain in trade by taking the advantage of the comparative advantage. The point 3,3 goes beyond the equilibrium point and the indifference curve clearly suggesting that the excess production has been exported and the shortage has been imported. It is because there are 12 hours available for production if both countries divide the time equally for the production of cheese and wine i.e. six hours is given for the production of both cheese and wine. Thus home country will be able to produce 3 units of cheese and 2 units of wine where as foreign country will produce 2 units of cheese and 3 units of wine. Thus the total production of cheese and wine is 5 units. In case the home country makes only cheese, it would have produced 6 units of cheese and similarly the foreign country would have produced 6 units of wine. Thus the total production of both cheese and wine ha increased by one unit. Thus the advantage has been taken.
The world price of cheese will come down as the cheese price will not be impacted in home country as the supply and demand balance is there whereas the supply of cheese in the foreign country will come down because of excess supply from the home country. The consumption of foreign country will witness growth in the consumption of cheese.
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A shown in the above figure the production curve for both the countries has shifted. This is to say that the shift in production curve is such that the home country produces more of cheese and the foreign country produce more of wine there by resulting in trade surplus (Leamer, 1985)..
1.5 The point F as shown in the above graph in the question can be the point of equilibrium if and only if the home country is efficient in producing more cheese and the foreign country is efficient in meeting the world demand of the wine. Thus in present case it is not possible as in achieving the equilibrium point F the production of both cheese and wine either have to be increased or the efficiency has to be improved. This is not possible in current state as the point F is lying well above the PPF of home country’s maximum possible output of cheese and the wine production is very low at the point F thereby resulting in imbalance.
2
The Graph can be plotted for the above data and it can be interpreted that the two countries when in Autarky produced total of 68 units of product P1 and 56 units of Product P2. This is autarky as both the countries are devoting four hours in the production of both the products. Thus in order to take advantage the country 1 that has efficiency in production of P1 devotes more hours in that and country 2 devotes more hours in production of P2. This will result in more production of of P1. This has been shown in table 2. Thus it can be said that the overall production of the economy has increased by contributing more to the products that devote more time production of goods in which they specialize and thus creating trade surplus in the economy. As seen above after contributing more hours to product P1 the total production has increased by 0.67 units which is beneficial for the economy.
2.1 From the given figure it can be said that for the production of 40 units of food the labor requirement is 40 and the capital required is also 40 whereas in the production of 30 units of the capital requirement is 60 and the labor requirement is jut 10. Thus for the production of food the requirement is one unit of labor and one unit of capital and for the one unit production of machine just 0.3 units of labor and 2 units of capital is required. Thus it can be said that the machine is capital intensive whereas food is labor intensive. This is because the requirement of labor in case of food is more than the machine and in case of machine the capital requirement has the major share in the production of per unit of machine and the labor has very less share(Maneschi, 1999).. It can be said that the labor requirement in the production of food is more than in the production of machine and that in machine the capital requirement is more than that in the production of food. Thus the country that is labor intensive i.e. has more supply of labor will produce cost efficient food as the country having surplus capital will have cost efficient production of machines thereby reducing the cost of production in the economy if the specialization is done in both the sectors.
According to Rybczinski theorem if the prices of goods are kept constant, the increase in one factor will result in the increased output of the goods which have extensive use of this factor in the production and at the same time reduction in output of the other good.
As shown above as the labor is increased the labor constraint as shown above will shift upwards and the capital constraint has kept unchanged. Thus the point of intersection will shift to point B. This shows that the output of machines will be reduced from S1 to S2 while the production of food will increase from C1 to C2
2.3 As shown in the diagram below the output for both the machine and food will improve as the inputs required for them have been doubled. However the increase will not be in proportionate manner as shown in the graph because according to the Rybczinski theorem the increase in productivity will not be proportionate. Thus since more capital is available this will take the share of labor available for food.
Thus it can be clearly seen that although the number of units has increased the food output has shifted towards the left whereas the machine output has shifted towards the left thereby showing an increase in machines is more than the increase in food with the increase in both the input variable
Increasing capital used in machine production
200 120 O Machine
100
Increasing labour F Increasing labour
used in food used in machine
production 80 M 20 production
100
O Food 80 200
Increasing capital used in food production
As seen above the there has been a shift in the production of machines as the increase in supply of capital has effected the increase in production of food. This is in accordance with the Rybczinski theorem. Thus although the supply of both labor and capital has increased but as stated in Rybczinski theorem the effect will be more on the production of that goods which is more input intensive which in this case is machines. Thus increased production of machines will result in less labor hours available for the production of food irrespective of the increase in the supply of labor. This is because the increase is in the same proportion. Had the increase in supply of labor had been more, the effect on production of food would have been there.
References:
Michael E. Porter (1998). Competitive Advantage of nations
Michael E. Porter (1998). Competitive Advantage: Creating and Sustaining Superior Performance
Edward E. Leamer (1985). Comparative Advantage, Growth, and the Gains from Trade and Globalization
Robert M. Stern (2011). Sources of International Comparative Advantage: Theory and Evidence
Andrea Maneschi (1999). Comparative Advantage in International Trade: A Historical Perspective
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