Problem Set 1 Economics 101 (International Economics) Problems 1:3 from Chapter 2 of Krugman and Obstfeld book (pg.

35).

1. Home has 1200 units of labor available. Let's call this endowment by L. The 2 goods that this economy produce are apples (we will call it "a") and bananas (let's call it "b"). The following are the unit labor requirements for both goods: a La = 3 a Lb = 2 If Home would use all of its labor to produce apples, how many apples would be able to produce? If it uses all of its labor to produce bananas, how many bananas would be able to produce? The amount produced would be equal to the current units of labor available (L) over the unit labor requirement for each good. The amounts are then: L 1200 = = 400 apples aLa 3 L 1200 = = 600 bananas aLb 2 a.) The Home's production possibility frontier can be seen in Fig. 1. In there we can see that the production possibility frontier has a slope of 3/2. The value of the slope is associated with the following question of the opportunity cost. b.) The opportunity cost of apples in terms of bananas can be understood as the cost of producing one more apple in terms of bananas. It is a cost because given the fact that the country resources are limited (1200 units of labor) if they want to produce one more apple, they have to stop producing a number of bananas (and that is the reason of the inverse relationship). More apples produced mean fewer bananas available and viceversa. The ratio between the labor requirements for both goods determines the opportunity cost, so in this case we get, aLa 3 = aLb 2 c.) In this economy (with 1 factor of production) the movement of labor will determine the supply to whichever sector pays the higher wage. So we have the following possibilities: p a Case 1: a > La pb aLb In this case the relative price of apples in terms of bananas is higher than the opportunity cost hence it is a good business to produce more apples. This situation will derive in specialization of Home in production of apples. p a Case 2: a < La pb aLb This case is the opposite of Case 1. Here the price of apples is lower than its opportunity cost, that means that Home will specialize in the production of bananas.

pa aLa = pb aLb This is the last case and here the conclusion seems obvious. The relative price of apples is equal to its opportunity cost which mean that Home will produce both goods. If there is no trade (autarky conditions), this has to be the relationship in order for Home country to have apples and bananas in the market. So the numbers in this case would tell us that the relative price of apples is equal to, pa 3 = pb 2 2. Now this answer is very similar but we are introducing here another country, Foreign, which possess the following characteristics (we'll denote the variable relative to this country with an * to differentiate them from Home country). L* = 800 Case 3: a* La = 5 a* Lb = 1 a.) We are asked about the production possibility frontier (PPF) for this economy. As in question 1, we have to calculate the amount of apples and bananas that would be produced if the specialization case (if the whole amount of labor available is used in the production of only apples and only bananas). The result is, L* 800 = = 160 apples a* 5 La L* 800 = = 800 bananas a* 1 Lb With this information we can draw the Fig. 2. b.) To construct the world relative supply we must first think about the concept of comparative advantage. We have to ask us what is the lower relative opportunity cost in any of the countries. To do so, let's look at the numbers, aLa a* < La aLb a* Lb 3 5 < 2 1 In this case, Home has a comparative advantage in producing apples. It could have been in any of the directions. The important point is that for Home it is good to specialize in the production of apples and sell some of them to Foreign. In the meantime, Foreign has a comparative advantage in the production of bananas, so it is a good deal for them to specialize en the production of bananas and sell some of them to Home. With this information we are able to construct the world relative supply function (RS). This one is presented in Fig. 3. The function RS is the world relative supply and just consider the fact that there is no production of apples if the world price drops below aLa/aLb (3/2). Do you know why? If the price is between aLa/aLb and a*La/a*Lb (3/2 and 5), there would be production of both goods in the world. The relative supply of apples in this point is 1/2. Can you explain it? Finally if the price is equal to a*La/a*Lb (5), foreign workers are indifferent between producing apples or bananas, so the RS curve will be flat again. 2

3. We are assuming that the relative demand takes the form: Demand for aples/demand for bananas = price of bananas/price of apples. a.) The relative demand curve takes the form showed in Fig. 3. It shows a negative relationship between relative prices and relative quantities (normal relationship). It is a convex function by the properties given at the question. b.) The point of intersection between the relative demand RD and the relative supply RS is in the point indicated as (1/2,2). So the relative price would be 2. c.) The solution is that Home will specialize in the production of apples and Foreign will specialize in the production of bananas and they would try to sell some part of the respective productions to each other. The questions that comes now is, does this make both countries better off? d.) To answer this question we will take a look at Fig. 4 and Fig. 5. In both figures we have drawn the "new" production possibility frontier for each country. As you can see, international trade makes the PPF for each country bigger. Home can "produce" more efficiently bananas, by specializing in the production of apples. Foreign can "produce" more efficiently apples, by specializing in the production of bananas. Both countries have the opportunity to reach higher levels of consumption of apples and bananas than if they were alone producing both goods. Note: You will find another figure in this solution. The Figure 2-3 is from the book. It is given because the book has a typo in that one and there are some letters and numbers missing. Please take a look and do the respective changes in your books.