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Chapter 3 Labor Productivity and Comparative Advantage The

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					Chapter 3
Labor Productivity and Comparative Advantage: The Ricardian Model

Problems
1.
        a. The production possibility curve is a straight line that intercepts the apple axis at 400(1200/3)
            and the banana axis at 600(1200/2).
        b. The opportunity cost of apples in terms of bananas is 3/2. It takes three units of labor to
            harvest an apple but only two units of labor to harvest a banana. If one foregoes harvesting an
            apple, this frees up three units of labor. These 3 units of labor could then be used to harvest
            1.5 bananas.
9. Gains from trade still exist in the presence of non-traded goods however the gains from trade decline
   as the share of non-traded goods increases. In other words, the higher the portion of goods which do
   not enter the international marketplace, the lower the potential gains from trade. If transport costs
   were high enough so that no goods were traded, then, obviously, there would be no gains from trade.
   Examples of non-traded goods include services such as haircuts, dentist,

Also answer the following:
   a) Define in your own words the Law of Increasing Opportunity Cost and give an example.
   As an economy increases its production of any good along its PPF, the cost of obtaining an additional
   unit of the good (in terms of other goods forgone) will be increasing
   The law of increasing opportunity cost is responsible for the bowed out shape of the PPF.
   Increasing opportunity cost arises because not all of the economy’s resources are equally well-suited
   to the production of a single good.
   b) Identify the basic questions with which modern trade theory is concerned.
   Modern trade theory addresses the following questions: (1) what constitutes the basis for trade? (2)
   At what terms of trade do nations export and import certain products? (3) What are the gains from
   trade in terms of production and consumption?
   c) Briefly describe the mercantilists’ view of trade.
   The mercantilists maintained that government should stimulate exports and restrict imports so as to
   increase a nation's holdings of gold. A nation could only gain at the expense of other nations because
   not all nations could simultaneously have a trade surplus.
   d) How did Smith’s views on international trade differ from those of the mercantilists?
   Smith maintained that with free trade, international specialization of resources in production leads to
   an increase in world output which can be shared by both trading partners. All nations simultaneously
   can enjoy gains from trade in terms of production and consumption. Smith’s view on trade was based
   on the principle of absolute advantage, i.e. the ability of a country to produce more of a good or
   service than competitors, using the same amount of resources.
   e) Both Smith and Ricardo contended that the pattern of world trade is determined solely by supply
        conditions. Explain.
   Ignoring the role of demand's impact on market prices, Smith and Ricardo maintained that a country's
   competitive position is determined solely by production (supply) cost conditions. Smith's trade
   theory is based on absolute costs, while comparative costs underlie Ricardo's trade theory.
   f) How does the comparative cost concept relate to a nation’s PPF? Illustrate how differently
        shaped PPFs give rise to different opportunity costs.
   The principle of comparative advantage can be explained in opportunity cost, which indicates the
   amount of one product that must be sacrificed in order to release enough resources to be able to
   produce one more unit of another product. The slope of the production possibilities curve (i.e., the
   marginal rate of transformation) indicates this rate of sacrifice. A nation facing a straight line
   production possibilities curve produces under conditions of constant costs, while production under
   increasing costs refers to a bowed out (i.e., concave) production possibilities curve.
   g) The gains from specialization and trade are discussed in terms of production gains and
       consumption gains. What do these terms mean?
   Production gains from trade refer to the increased output of goods and services made possible by the
   international division of labor and specialization. Consumption gains from trade refer to the
   increased amount of goods made available to consumers as the result of international trade.
   h) Why is it that the gains from trade could not be determined precisely under the Ricardian trade
       model?
   Because the Ricardian trade model only determines the boundaries of the mutually beneficial trade
   area and is based on the supply side of the market ignoring the demand side.
   i) What is meant by the theory of reciprocal demand? How does it provide a meaningful
       explanation of the international terms of trade?
   The theory of reciprocal demand suggests that if we know the domestic demands expressed by both
   trading partners for both products, the equilibrium terms of trade can be defined.
   j) The hypothetical figures in the table give seven alternative combinations of wheat and cloth that
       the United States and the United Kingdom can produce if they fully use all factors of production
       at their disposal with the best technology available to them. In Autarky the U.S. produces and
       consumes at point D and the U.K. at point C’.

  Production Possibility Frontiers for Wheat and Cloth in the United States and the United Kingdom

                            United States                    United Kingdom
                            Wheat       Cloth                  Wheat     Cloth
                      A          180         0          A'          60        0
                      B          150        20          B'          50       20
                      C          120        40          C'          40       40
                      D           90        60          D'          30       60
                      E           60        80          E'          20       80
                      F           30      100           F'          10      100
                      G            0      120           G'            0     120


ANSWERS TO PROBLEM
                                                           U.S.
        130
        120                            U.S. PPS
        110
                                      MRT = 0.67
        100
         90
         80                                                                       ToT (1C:1W)
         70
Cloth




         60                                                     D
         50
         40
         30
         20
         10
          0
                0
                      10
                           20
                                 30
                                      40
                                            50
                                                 60
                                                      70
                                                           80
                                                                90
                                                                      100
                                                                            110
                                                                                  120
                                                                                        130
                                                                                              140
                                                                                                    150
                                                                                                          160
                                                                                                                 170
                                                                                                                       180
                                                                                                                               190
                                                                Wheat




                                                           U.K.
                130
                120
                110
                100
                 90
                 80
                                                                                              ToT (1C:1W)
        Cloth




                 70
                 60
                 50
                                                                     U.K. PPS
                 40
                 30                                    C'            MRT = 2.0
                 20
                 10
                  0
                      0


                                10


                                       20


                                                 30


                                                           40


                                                                     50


                                                                             60


                                                                                        70


                                                                                                    80


                                                                                                                90


                                                                                                                         100




                                                                Wheat
     Is the opportunity cost of the two countries constant, increasing, or decreasing?
     The opportunity costs are constant, the PPSs are straight lines.

     Calculate the marginal rate of transformation (MRT) of each nation.
     MRTUS = 0.67 and MRTUK = 2

     Base on the MRT of each nation, should the two nations specialize according to the principle of
      comparative advantage? If so, in which product should each nation specialize?
     Yes because the US has comparative advantage on the production of wheat and the US on the
      production of cloth. US specializes on wheat and the UK on cloth.

     Assuming both nations completely specialize in the good in which they have comparative
      advantage, how much cloth or wheat is produced in the U.S.? How much cloth or wheat is
      produced in the U.K.?
     US will produce 180 wheat and UK will produce 120 cloth.

     Assume the U.S. and the U.K. reach a terms of trade of 1 to 1 and suppose that the U.S. decides
      to export 70 bushels of wheat to the U.K. Locate on each nation’s graph the new consumption
      combination of wheat and cloth, are the new combinations outside each nation’s PPS’s? If so,
      why does trade make consumption outside the PPS possible?
     The consumption combinations of cloth and wheat for both countries lie outside their PPSs
      because the gains in production due to specialization allow countries to consume outside the
      PPS.

Gains from Specialization and Trade: Constant Opportunity Cost

(a) Production Gains from Specialization
                  Before Specialization           After Specialization           Net Gain (Loss)
                  Wheat         Cloth             Wheat           Cloth         Wheat      Cloth
     U.S.                90           60                 180            0           90         -60
     U.K.                40           40                   0          120          -40          80
    World               130         100                  180          120           50          20
(b) Consumption Gains from Specialization
                  Before Specialization           After Specialization           Net Gain (Loss)
                  Wheat           Cloth           Wheat           Cloth         Wheat      Cloth
    U.S.                 90            60                110           70           20         10
   U.K.                  40            40                 70           50           30         10
   World                130           100                180          120           50         20

				
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