Econ 404

Answers to Chpt 2 problems

3. The OC of 1 unit of fish (F) in Iceland is 1 unit of wheat (W); The OC of 1 unit of fish in Finland is 2 units of wheat ; So Iceland has comparative advantage in fish and Finland has comparative advantage in wheat. Each worker in Finland can produce 2 fish compared to Iceland workers 1 and 4 wheat compared to Iceland workers 1 wheat so Finland has absolute advantage in both goods. 4. Iceland: when PF>PW workers will only produce fish, so when PF/PW > 1 workers will only fish, and when PF/PW < 1 workers will only produce wheat; this implies the autarkic supply curve is horizontal line at 1. For Finland when 2PF>4PW workers will only produce fish, so when PF/PW > 2 workers will only fish, and when PF/PW < 2 workers will only produce wheat so autarkic supply curve is horizontal line at 2. Since consumers want to consume both goods, we can infer that in autarky the relative price of fish is 1 and in Finland it is 2. We use this to derive the budget line. You can start with either worker (since in autarky there will not be complete specialization) and you will get the same answer. Note: It is sometimes convenient to refer to PF/PW as p. Iceland Fishers budget constraint: PF =PFCF + PWCW where C is consumption. The income of the worker is the price of fish since he produces 1 unit. To find intercepts of budget line, see how much fisher can consume if he spends all his income on fish or all on wheat. Fish: PF/ PF=1; Wheat: PF/ PW =1. Finland Wheat producers budget constraint: 4 PW = PFCF + PWCW , where the wheat producer earns 4 PW. To find intercepts of budget line, see how much worker can consume if he spends all his income on fish or all on wheat. Fish: 4PW/ PF=4/p=2; Wheat: 4PW/ PW =4

Econ 404

Answers to Chpt 2 problems

Fish

1.5

Icelandic worker budget line; dashed line is after free trade.

1

0.5

Wheat
0 0 0.5 1 1.5

Fish
3.5 3 2.5 2 1.5 1 0.5

Finnish wheat producer budget line; dashed line is after free trade.

Wheat
0 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 5.5 6 6.5 7 7.5

Econ 404

Answers to Chpt 2 problems

5. Let I stand for income and note that spending on fish is given by PFCF .We can express the demand side assumptions by (PFCF)/I =0.2 and (PWCW)/I =0.8

This is math for consumers spend 1/5 of income on fish and 4/5 on wheat. Now we take the ratio of spending on fish to wheat, note that income I will cancel out so we get (PFCF)/(PWCW) =0.2/0.8 =0.25 We want relative demand as a function of relative price so we rewrite this to get CF/CW=0.25(PW/PF) If we let p stand for PF/PW we can see more clearly that this is a non-linear function in p: CF/CW=0.25/p

6. The key part of the world relative supply curve is the part where 1< PF/PW<2, since this is where Iceland is producing only fish and Finland is producing only wheat. It is useful to think of the production information as production functions, so for Iceland we have QF=L where L is the number of workers making fish. When Iceland specializes, it has 1 million workers so it produces 1 million fish. In Finland , we know QW=4L, so when all 1.5 million Finish workers make wheat, they produce 6 million units of wheat. Hence the relative supply when both countries specialize is (1 million F/6 million W)= 1/6.

7. We want to find the equilibrium world relative price p given demand CF/CW=0.25/p. This is essentially a trial and error since the supply curve in non-continuous. (Or you can graph exactly and see where they cross the graph below is precise). Lets assume they cross at the vertical part of the supply curve, which we know occurs where QF/QW=1/6. We equate relative quantity supplied to relative quantity demanded and solve for p: QF/QW=1/6 and CF/CW=0.25/p so 1/6=0.25/p and so p=1.5 In this case our guess was correct since 1.5 is between 1 and 2. This means Iceland specializes in fish and Finland specializes in wheat. Workers in both countries are better off since their budget lines have pivoted out (see graphs above and below). Note that to find new budget lines we have to use income of specialized workers (fishers in Iceland and wheat producers in Finland) together with the world relative price 1.5. In Iceland, the 3

Econ 404

Answers to Chpt 2 problems

fisher still earns PF and so can still consume 1 fish (PF / PF ) and if he spends all his income on wheat he can consume PF/PW which is now 1.5 (compared to 1 in autarky). In Finland, the wheat producer earns 4PW which still allows him to consume 4 units of wheat and now 4/p = 4/1.5=2.67 units of fish (compared to 2 in autarky).

relative price of fish

3.5

World relative supply and demand for fish/wheat

3 2.5 2 1.5 1 0.5

relative quantity of fish

0 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

8. If Finland had 3 million workers instead of only 1.5 million, the vertical part of the supply curve would be at (1 million F/12 million W)= 1/12. This means the demand curve would intersect the supply curve at p= 2, so that now Finland would produce both fish and wheat, although Iceland would still specialize. This means that Icelandic workers would gain more from trade but Finish workers would not gain from trade (since In Finland the autarkic price was 2).