Week 2 Assignment

1945 Words Dec 11th, 2012 8 Pages

Problem set

Exercise 2.1
Assume there are just two countries in the world, i.e. the European Union (EU) and the Rest of the World (RW). Both countries produce and consume 2 products: bicycles (b) and apples (a). Per bike, the EU puts in 3 hours of labour while the RW puts in 5. Per ton of apples, the EU needs 2 hours v. the RW 1 hour of labour. A further given is that the EU has 2400 hours of labour available v. RW 1600. The world relative demand has the following form: demand for bikes/demand for apples = price of apples/price of bikes.
a. How high are the opportunity costs of a bike in the EU and the RW in the absence of
In your answer you are to use the terms opportunity costs and/or relative prices.

Home has a comparative advantage in the production of cloth and steel, where it is relatively the most efficient. We also say that Foreign has a comparative advantage in the production of cloth, where it is least disadvantaged compared to Foreign. Although Home has an absolute cost advantage for both sectors (Brakman p65).

However put Labour in consideration, Home only have an advantage over Foreign in the steel sector; while Foreign has a comparative advantage in production of cloth (where it is least disadvantaged).

At Home, the relative price of cloth in term of steel is: 10/5 or 2 The relative price of steel in term of cloth is: 5/10 or 0.5 In Foreign the relative price of cloth in term of steel is: 50/50: 1 The relative price of steel in term of cloth is also: 50/50: 1

The relative price unit of both products in both countries is also called the opportunity costs.
b. Draw the production possibility curve for each country and indicate (both graphically and in words) what the advantage of trade is for each country.

[pic]

The light gray line indicates the gain from trade for both countries.
Home: Foreign:
L/a LC: 100 L/a LC: 100
L/a LS: 200 L/a LS: 100

Home: 1000/5 = 200 steel 1000/10 = 100 cloth
Foreign: 5000/50 = 100 steel 5000/50 = 100 cloth

Exercise