Feenstra and Taylor

Chapter 2 Problems
Ricardian model of trade

1.Ricardo's original example.

Instead of the text assumption (added to Ricardo) that the amount produced was 1000 (barrels of wine and yards
of cloth), it won't hurt to assume that the amount produced is 7200 (bottles of wine or inches of cloth). We have
as our production functions for England:
Qwine = MPLwine * Lwine
7200 = MPLwine * 120

So each worker in England produces 7200 / 120 = 60 bottles of wine a year.

The activity requirement for wine in England is 1/60 of a year of labor.

Use the same logic to construct all the production functions:

ENGLAND PORTUGAL

Wine Qw = 60 Lw Qw = 90 Lw
Cloth Qc = 72 Lc Qc = 80 Lc

Portugal has the absolute advantage in both goods. A worker there is 50 percent more productive in the
wine industry but note, only 10 percent or so more productive in the cloth industry.

We can find prices for the goods by assuming that the wage in England is 7200 pounds a year and
the wage in Portugal is 14,400 escudos per year, and that prices reflect only the labor cost of production.

ENGLAND PORTUGAL

Price of wine 7200 / 60 = 120 pounds 14,400 / 90 = 160 escudos

Price of cloth 7200 / 70 = 100 pounds 14,400 / 80 = 180 escudos

Price ratio (Pw/Pc) 1.2 0.888

Price ratio (Pc/Pw) 0.833 1.125

The English have the low price ratio for cloth, and the Portuguese for wine.
If you draw a production possibility frontier for each country with wine on the horizontal axes, you will
find that the slopes are the (negative of) the price ratio Pw/Pc; if cloth is on the horizontal axes,
the slopes are the negative of Pc/Pw.

It is possible to use the text formula for prices, Pw / Pc = MPLc / MPLw, but it is more illuminating
assume a wage and work out the price.

What would happen if you assume the price reflects not just the labor cost but a 10 percent markup in
both industries and in each country? The prices will differ, but will the relative prices?
Questions 2-5 refer to gains from trade in a Ricardian model.
Data given: Production functions:

HOME FOREIGN

Cars Qc = 3 Lc Qc = 2 Lc

TVs Qtv = 2 Ltv Qtv = 3 Lc

Labor force: 400 400 (increased from the text example).

Wage: $ 6000 900 (not given in text)

Absolute advantage: Home has the absolute advantage in cars and Foreign in TVs.

Comparative advantage: Follows absolute advantage when each country has an absolute advantage in one
good. But can also be seen by looking at prices:

HOME FOREIGN

Pcars $ 6000 / 3 = $2000 900 / 2 = 450

Ptv $ 6000 / 2 = $ 3000 900 / 3 = 300

Pc/Ptv 2/3 1.5

Hence Home is the low relative cost producer of cars, and has a comparative advantage in cars.

Ptv / Pc 3/2 = 1.5 1/1.5 = 2/3

Hence Foreign is the low relative cost producer of TVs, and has a comparative advantage in TVs.

In drawing the graphs, I assumed different utility functions for each country which would lead to the
results described in the text.

Since Home consumes 900 cars and 200 TVs, they will be spending 900 * $ 2000 = $ 1.800,000 on cars and
200 * $ 3000 = $ 600,000 on TVs for a total expenditure of $ 2,400,000.
Note that 75 percent of their income (18/24 = ) is spent on cars, which means that they must consider cars
more important in their utility function. The Cobb-Douglas utility function which would predict this behavior
is:
U = X 0.75 * Y 0.25
Note also that Foreign is consuming 200 cars and 900 TVs, and hence spending 200 * 450 = 90,000 on cars
and 900 * 300 = 27,000 on TVs, so they are spending only 25 percent of their income on cars. This behavior
would be predicted by the Cobb-Douglas utility function
U = X 0.25 * Y 0.75

These utility functions were used in the program that created the following graphs of the pre- and post-trade
situations. The text asks you to assume that the price ratio after trade is Pcars / Ptv = 1.0
They may be used to find that the utility of each country increased from a score of 291.3 before trade to 394.8
after trade, although you should be cautious about assuming that the numbers indicate anything other than a gain
in utility for the representative consumer (who may not represent every single individual).

In the trade situation, each country exports 300 units of the good it has a comparative advantage in.
You should sketch the trade triangle in each of these graphs. (See question 5 c).
Question 6. Absolute and Comparative Advantage

HOME FOREIGN Absolute advantage

Bicycles Qb = 4 Lb Qb = 2 Lb HOME more productive in bicycles

Snowboards Qs = 6 Ls Qs = 8 Ls FOREIGN more productive in snowboards

COMPARATIVE ADVANTAGE:

Opportunity cost of bicycles at home:

Producing 4 bicycles means giving up the opportunity to make 6 snowboards
Opportunity cost of 4 bicycles = 6 snowboards
Opportunity cost of 1 bicycle = 1.5 snowboards.

Note that prices will reflect opportunity costs:

if wages at home are $ 60 an hour,
Pb = $ 60 / 4 = $ 15
Ps = $ 60 / 6 = $ 10, and hence Pb / Ps = $ 15 / $ 10 = 1.5

In Foreign,
Producing 2 bicycles means giving up the opportunity to make 8 snowboards.
Opportunity cost of bicycles = 4 snowboards.

Hence HOME is the low opportunity cost producer of snowboards and therefore has the comparative
advantage in snowboards.

For snowboards:
Opportunity cost of 6 snowboards at HOME = 4 bicycles
Opportunity cost of 1 snowboard = 4/6 bicycles.

Opportunity cost of 8 snowboards in FOREIGN = 2 bicycles

Opportunity cost of 1 snowboard = 2/8 bicycles.

FOREIGN is the low opportunity cost producer of snowboards.

Question 7. Fill in the blanks.

HOME FOREIGN

TV INDUSTRY CAR INDUSTRY TV INDUSTRY CAR INDUSTRY

Wage = $ 12 Wage = ? Wage = ? Wage = 6

MPL = 2 MPL = ? MPL = ? MPL = 1
Price = ? Price = $ 4 Price = 3 Price = ?

Basic things to keep in mind:

1.Wages are set in a national labor market. They will be the same in both industries in a country, since
labor is assumed to be of the same quality and to be able to migrate freely between industries.
Hence both wages in the HOME country are $ 12, and both wages in the FOREIGN country are 6.

2.Profits are maximized by hiring labor until P * MPL = wage

Hence in HOME Ptv = $ 12 / 2 = $ 6 and MPLc = $ 12 / $ 4 = 3

and in FOREIGN MPLtv = 6 / 3 = 2 and Pc = 6

The autarky price ratios for Ptv / Pc = $ 6 / $ 4 = 1.5 in HOME and 3 / 6 = in FOREIGN.
FOREIGN has the low relative price (= low opportunity cost under Ricardo's assumptions),
and therefore has the comparative advantage in TVs.

If the world relative price Ptv / Pc = 1.0 after trade, each country will export the good in which they have a
comparative advantage: HOME will export cars, and FOREIGN will export TVs.

Both countries will gain from the opportunity to trade at a price ratio different than their initial price ratio, but
that does not imply that standards of living will be the same.

Absolute advantage will determine relative living standards.

If we assume that the wage rate does not change after trade, and that both countries specialize, then
both countries will have the price of their export good stay the same:
but in HOME the price of TVs will fall from $ 6 to $ 4, meaning that the nominal wage of $ 12 in HOME will
buy either 3 TVs (a gain of one) or 3 cars (same as before trade).
And in FOREIGN the price of cars will fall from 6 to 3, which means that the wage of 6 will now buy
either 2 cars (a gain of one) or 2 TVs (same as before trade).

Both countries have gained, but the Foreign standard of living remains lower than that at home.
Questions 9-11. Changes in productivity and terms of trade.

Start from the basic chapter model:

HOME FOREIGN

Wheat Qw = 4 Lw Qw* = Lw*

Cloth Qc = 2 Lc Qc* = Lc*

LABOR FORCE 25 100

WAGES $ 60 20

Given the labor force in HOME, its maximum production of wheat is 100 and its maximum production of cloth
is 50.

Note that Home has an absolute advantage in both goods, a comparative advantage in wheat.
Foreign has a comparative advantage in cloth, since the opportunity of cloth is foreign is 1 wheat, and the
opportunity cost of cloth in home is 2 wheat. We expect the pattern of trade to be HOME exporting wheat and
FOREIGN exporting cloth.

The autarky prices at HOME will be, assuming the wages given (different wages would not change the relative
prices) are, since P * MPL = wage in both industries, calculated as P = wage / MPL

Hence in HOME, wheat will cost $ 60 / 4 = $ 15 and cloth will cost $ 60 / 2 = $ 30.
So Pw / Pc = $ 15 / $ 30 = in HOME autarky.

In Foreign, Pw = Pc = 20, so Pw / Pc = 1.

The world relative price will be between the autarky relative prices, hence in the range 1/3 to 1, so a value of 2/3
for the world relative price is quite possible.

Question 9. Changes in Labor Force and Productivity.

a. If labor force doubles in HOME, the PPF will shift out parallel to itself; the maximum production of
each product doubles. But the production functions don't change, so the autarky prices of the products don't
change. We will see in problem 11 that the world trade price probably WILL change.

b. Technical progress in the wheat industry leads to higher MPL in wheat; for example let Qw = 6 Lw.
Then the price of wheat = wage / MPL = $ 60 / 6 = $ 10, and the relative price of wheat changes to
Pw / Pc = $ 10 / $ 30 = 1/3.

An increase in the productivity of labor in the cloth industry would raise the relative price of wheat by
lowering the price of cloth. Suppose that after the increase in productivity in the wheat industry to MPL w = 6,
the production function in the cloth industry changed to Qc = 10 Lc. Then the price of cloth would be
Pc = $ 60 / 10 = $ 6, and the relative price of wheat would be Pw / Pc = $ 10 / $ 6 = 1.67. Note that the increase
in the relative price of wheat would be that HOME actually lost its comparative advantage in wheat, and the
pattern of trade would shift.
Added: Effect of productivity change on the terms of trade.
The initial trade situation may be replicated by the following graph:
(the code is for the benefit of your instructor, who is working on a program to replicate the economic models in
the Feenstra text; you can safely ignore it. (offers 100 50 100 100 1.2 0.4). The numbers refer to the maximum
production of wheat and cloth in Home and Foreign; the utility function is of the CES form with elasticity of
substitution = 1.2 and wheat getting a weight of 0.4 in the utility function).

If the CES utility function is used to evaluate the gains from trade in HOME, we will find that HOME utility
increases from 25.48 to 40.09, a gain of 57 percent.

The change in the wheat production function from Qw = 4 Lw to Qw = 6Lw lowers the autarky relative price of
wheat, so the new offer curves are (offers 150 50 100 100 1.2 0.4). Note that in the new graph, the HOME
relative price of wheat in autarky would be 0.33, and the terms of trade turn against HOME. The new world
relative price would be 0.48.

The decline in the terms of trade does not however mean that the country is necessarily worse off, since its
productivity has also increased. In this case, we don't have Jagdish Bhagwati's immiserizing growth.
Autarky utility would have been 30.55, and trade utility will be 49.28, so it increases from the previous trade
situation despite the decline in terms of trade.
Question 10. An increase in the terms of trade increases utility

The following graph shows Home with the original production functions and a Cobb-Douglas type utility
function, with wheat and cloth equally important -- that is, U = (sqrt W * C). The original terms of trade are
Pw / Pc = 2/3, and I assume that the new terms of trade will be Pw / Pc = 1 (that is, that Home is able to trade at
Foreign's relative price).

The red line is Home's production possibility frontier, the magenta line has the terms of trade at Pw/Pc = 2/3, so
that 100 bushels of wheat will buy 66.67 yards of cloth, and the blue line has the terms of trade at Pw/Pc = 1,
so that 100 bushels of wheat will buy 100 yards of cloth.

Home is exporting wheat, and since with a Cobb-Douglas utility function it will continue to spend the same
amount on wheat, it will continue to purchase the same amount of wheat if the price of wheat is unchanged.

Indifference curves are sketched in, but clearly with the amount of wheat consumed at home the same, and the
amount of cloth rising, home utility would increase as the terms of trade improved.

Notes:
If the terms of trade rose to more than 1, Home's utility would continue to increase. Foreign would
begin to export wheat. This will clearly not happen unless there is a third country producing cloth
for both Home and Foreign to import.
If the terms of trade had remained at home relative prices, Home utility would not have improved.
You should keep this in mind in reading question 11.
Question 11. Home does not see terms of trade improvement.

The offer curves drawn by the text result in the after-trade price ratio in Home being the same as the pre-trade
price ratio in home. As noted in the previous question, this means Home does not gain at all from trade:
their consumption bundle does not change although they specialize in the production of wheat, they will export
half their wheat in order to buy their pre-trade consumption of cloth.

In practice, since transportation costs are greater than zero, this means trade will not be profitable for individuals
to engage in, and hence there would be no trade at all between the two countries.

Question 12. NAFTA, Mexico and the United States

The fact that the United States is a much larger country than Mexico means that the terms of trade are likely to
be very close to the autarky trade price ratios in the United States for most products. This in turn means that the
United States will probably not see its utility rise dramatically, and that most of the gains will go to Mexico.

NAFTA was a very controversial trade pact in both the US and Mexico. The controversy cannot be
explained by the Ricardian model, which demonstrates convincingly the gains from trade for the
representative consumer whose indifference curves are show on the graph in Question 10. It is better
explained by the fact that not everyone is a representative consumer, and that specific consumers may benefit
greatly from trade, and other specific consumers can be harmed. We will see in the next chapter that the specific
factors of production can be harmed by trade, and in the chapter on the Heckscher-Ohlin model that the
distribution of income between workers and capitalists will be changed by trade, and in fact that at least one
factor of production must lose when prices change as a result of trade.