ECO364: Practice Ricardian Problem Two goods: Clothing and Food. Two countries: Home and Foreign.

There are 200 workers in Home and 300 workers in Foreign. For Home, each unit of labor can produce 2 units of clothing or 2 units of food. For Foreign, each unit of labor can produce 1 unit of clothing or 2 units of food. DC is demand/consumption for clothing, DF is demand/consumption for food QC is production of clothing, QF is production of food. MU(DC) is the marginal demand of clothing and MU(DF) is the marginal demand of food.

p=

pc as the relative price of clothing to food pf D RD = C is relative demand. DF

! The utility function is identical and homothetic across countries such that
!
0.5 0.5 U ( DC ,DF ) = DC DF

a) Which country has an absolute advantage in each good? Recall that an absolute ! advantage comes from higher productivity. In the clothing sector, Home has an absolute advantage. In the food sector, each country has identical productivity, so neither country possesses an absolute advantage. b) Which country has a comparative advantage in each good? Home has a comparative advantage in Clothing while Food possesses a comparative advantage in Food. How do we know this? Recall that where a ij reflects unit labor requirements for country i in good j, Home will have a comparative advantage in Clothing if and only if
F acH ac < F! H aF aF

Recall that the marginal product of labor is 1/a. We can then plug in the unit labor requirements to obtain the inequality

0.5 1 < "1 < 2 0.5 0.5

This inequality confirms that Home possesses a comparative advantage in Clothing and Foreign possess a comparative advantage in clothing. Recall that with two countries and two goods, if one country possesses a comparative advantage in one good, the other country must possess a comparative advantage in the other good. c) Draw the PPF for each country, label all relevant points including the slope of the PPF. HOME FOREIGN QC 400 QC

slope = "1 = "

H aF H aC

slope = "0.5 = "

300

F aF F aC

!
400 QF

!
600 QF

d) From utility maximization, we know that relative demand curve is defined by the MU ( DC ) pC equation = = p . Use the Cobb-Douglas utility function to explicitly MU ( DF ) pF solve for this expression in terms of DC, DF, and p. Draw this curve with the relative price of clothing on the vertical axis and relative demand on the horizontal axis. ! We can solve for marginal utility as follows
$ DF ' 0.5 MU ( DC ) = = 0.5D D = 0.5& ) "DC % DC ( 0.5 0.5 $ DC ' 0.5 " ( DC DF ) 0.5 #0.5 MU ( DF ) = = 0.5DC DF = 0.5& ) "DF % DF ( ! Substituting in these expressions # DF & 0.5 0.5% ( MU ( DC ) ! $ DC ' = p" =p MU ( DF ) # DC & 0.5 0.5% ( $ DF '
0.5 0.5 " ( DC DF ) #0.5 C 0.5 F

" DF % 0.5 0.5 $ ' " DF % " DF % DF # DC & =p ' $ ' = 0.5 = p ( $ DC " DC % # DC & # DC & $ ' # DF &

0.5

! e) Draw the relative supply curve for each country in autarky. In autarky, does the shape of the relative supply curve depend on country size?
Recall that a relative supply curve maps out the relative prices at which relative quantities are supplied. More clearly, recall that price equals marginal cost for each good such that for clothing at home (for example)
H H pC = waC

Consequently, the relative price at which clothing is supplied (relative to food) in autarky will be !
H H H pC waC aC 1 = = H = =1 H H pF waF aF 1

Similarly, the relative price at which clothing is supplied relative to food in the South in autarky will be !
F F F pC waC aC 1 = = F = =2 F F pF waF aF 0.5

This can be expressed graphically as Pc/pF 2 1

!
PcF/pFF PcH/pFH

QC/QF No. The relative supply curve in autarky does not depend on country size.

f) Calculate autarky production and consumption levels. Hint: Use the autarky PPF for each country together with the equilibrium condition RS=RD. The first thing that is necessary is to introduce the RD (relative demand) curve into the above analysis. Because preferences are identical and homothetic across countries, we can apply the same relative demand curve to each country. Pc/pF 2 1 RD QC/QF Recall that in an autarky economy, production equals consumption for each good DC = QC ,DF = QF . Note from the class notes that the PPF (for Home) can be written as
!
H H H H QC aC + QF aF = LH

PcF/pFF PcH/pFH

Substituting in the unit labor requirements and the labor endowment.

! H + 0.5Q H = 200 " Q H + Q H = 400 0.5QC F C F Recall that in equilibrium QH 1 QH H H RD H = RS H " C = " C = 1 " QC = QF H H QF p QF ! Therefore
!
H H H H QC = QF = DC = DF = 200

Similarly, we can perform the same arithmetic for the South

F F F F QC aC + QF aF = LF F F F F QC + 0.5QF = 300 " 2QC + QF = 600 QF 1 QF 1 F F RDF = RS F " C = " C = " 2QC = QF F F QF p QF 2 ! F F F F F Q !C + 0.5(2QC ) = 300 " 2QC = 300 " QC = 150,QF = 300

!
!

g) Now assume that these economies open up to international trade. Draw the relative World demand and supply curvs on a separate diagram. Indicate where these curves cross. What are the production levels in each country? Do we see specialization? Pc/PF 2 1.5 1 RD3 400/600=2/3 RS RD2

RD1 (QCN+ QCS)/ (QFN+ QFS)

As in the class notes, the world RS function will be a step function. Recall that at the point where RS is vertical, this represents each country being completely specialized with Home producing clothing and Foreign producing food., therefore world relative supply of clothing to food will be
LH 200 H F H QC + QC QC 400 2 aH = F = C = 0.5 = = F H F 300 600 3 L QF + QF QF F 0.5 aF

How do we know that the RD curve will intersect RS where RS is vertical? By substituting in the relative quantity 2/3 into the RD curve, we get a value of 3/2 ! which is between 1 and 2. Suppose we had substituted 2/3 into the RD curve, and gotten a value greater than 2. In this case, we would know that RD cut the top horizontal segment as in RD2. If it gave a value less than 1, we would know RD would be as in RD3. Because it cuts in this vertical segment, we know that both countries specialize with Home producing 400 units of clothing and Foreign producing 600 units of Food.

h) Assume that trade is balanced, and that the value of consumption is equal to the value of production such that pC DC + pF DF = pC QC + pF QF . Divide by the price of food to obtain the expression pDC + DF = pQC + QF . Use this expression together with the results in part (g) and the equilibrium condition RS=RD to find consumption levels for both goods. What is the pattern of trade? Do countries ! gain from trade? !

We can use the economy-wide budget constraint for each country (not the PPF!) to solve for consumption patterns. For Home, we have:
H H H H pc DC + pF DF = pc QC + pF QF

Dividing by the price of food and noting that Home specialized in Clothing and noting that the equilibrium relative price of clothing to food is 3/2 ! 3 H H DC + DF = 600 2 Now recall that

! QH 1 H H QC 2 DC 2 2 H H C RD = RS " H = " H = " H = " DC = DF QF p QF 3 DF 3 3 Substituting in 32 H H H H DF + DF = 600 " DF = 300,DC = 200 23 !

H H

For Foreign

F F F F pc DC + pF DF = pc QC + pF QF

Dividing by the price of food and noting that Foreign specialized in food and noting that the equilibrium relative price of clothing to food is 3/2 ! 3 F F DC + DF = 600 2 Now recall that

! QF 1 F F QC 2 DC 2 2 F F C RD = RS " F = " F = " F = " DC = DF QF p QF 3 DF 3 3 Substituting in 32 F F F F DF + DF = 600 " DF = 300,DC = 200 23 !

F F

In sum, we see the following production and consumption patterns

H H F F DF = 300 DC = 200 DF = 300 DC = 200 H H F F QF = 0 QC = 400 QF = 600 QC = 0

Because Home consumption of Food is greater than production and consumption of clothing is less than production. We know that Home exports clothing and imports Food. The opposite pattern holds in Foreign. Do countries gain? We see that Home consumes as much clothing as before but consumes more food so Home is better off. Foreign consumes the same amount of food but more clothing, so Foreign gains as well. Consequently, both countries gain from trade.