Download Answers to Exercise 1 Question 1 (a) One of the most important

Answers to Exercise 1
Question 1
(a) One of the most important pillars of the Mercantilist view is that resources in the world are
Static
The central thinking of the mercantilist was therefore the view that a Nations wealth is reflected in
the amount of precious metals (Gold and Silver) it accumulates.
Economic activity in this setting can therefore be viewed as a Zero-Sum game
Employed the labor theory of value
Economy is operating under less than full employment
Favorable balance of trade (Exports > Imports)
(b) Why holding of precious metals important to nation states.
----- A nations wealth and wellbeing was tied to the accumulation of these metals
Question 2
Excess gold holdings by means of a trade surplus
prices and therefore leads to inflation
-------- trade surplus
increase the money supply
increasing
less competiveness
……….Zero trade balance in the long run
(b) Price elasticity refers to the ratio between the percentage change in quantity demanded of a
given product and the percentage change in its price.
e=
∆𝑄⁄
𝑞
∆𝑝⁄
𝑝
Since quantity demanded varies inversely with price, price elasticity will have a negative sign.
Economic convention often ignores the negative sign, but it is understood that e’s value would be
less than zero i.e. negative.
e > 1 (ignoring the negative sign) this means the percentage change in quantity demanded for a
given price change is greater than the percentage change in price
demand is elastic
e=1
e<1
demand is unit-elastic
demand is inelastic
When the relative change in quantity is greater than the relative change in the price means
demand is elastic
total expenditure on the product increases when price falls (quantity demanded increases)
and falls when price increase (quantity demanded falls)
Trade surplus leads to increase income
increases in prices
expenditure of the traded good (quantity demanded falls)
decrease in total
Question 3
Adam Smith
Adam Smith perceived a nation’s wealth to be reflected in its productive capacity and not in the
holding of precious metals
Self-interest would lead individuals to specialize in and exchange goods and services based on
their own special abilities.
Division of labor and specialization would lead to increased productivity.
Nations should therefore specialize in and export the good in which they have an Absolute
Advantage (that is the good in which less resources is used in its production than your neighbor)
David Hume
Species accumulation by means of a trade surplus would lead to increases in the money supply
which leads to increases in prices and wages and therefore inflation thus reducing the
competitiveness of a country.
Question 4
Internal Exchanges (Autarky)
Wheat in terms of Cloth
US
1 wheat
=
1⁄ cloth
3
UK
1 wheat
=
1 cloth
US has Absolute Advantage in cloth production because they use less resources in its production
compared to the UK
Cloth in terms of Wheat
US
1 cloth
=
3 wheat
UK
1 cloth
=
1 wheat
UK has Absolute Advantage in cloth production, because less resources is used in its production
than in the US
International Trade ( 1 cloth = 2 wheat)
UK export cloth if they get 1 wheat or more
US would buy cloth if it cost 3 wheat or less
The trading price limit between the two countries is therefor:
1
and
3
for cloth
If international price is therefore 1cloth = 2 wheat
UK gain 1 wheat more from trade
US save 1 wheat from trade
So, there is gain from trade between UK and the US
Question 5
Labor Constraint
UK has 500hrs of labor of which:
300hrs goes to cloth production
200hrs goes to wheat production
UK
Wheat
Cloth
0
75
50
0
Question 6
Total UK resources 500hrs
Wheat
Cloth
0
125
It is advantageous for the UK to produce cloth and trade it with the US at the barter price of 1
cloth = 2 wheat since it has an absolute advantage in the production of cloth than the US.
(b) Trading Situation for UK (1 cloth = 2 wheat)
Cloth
Total Domestic production
wheat
125
Exports
40
Total
85
0
imports
80
80
Consumption in the trading situation is 85 cloths and 80 wheat
To determine by how much consumption has increased post-trade we need to calculate the
autarky situation and compare it with the trading situation.
Autarky Situation for the UK
Cloth
Wheat
300hrs for cloth production
75
0
200hrs for wheat production
0
50
There is an increase in consumption for both goods in the trading situation by:
10 cloths and 30 wheat for the UK
Question 7
Comparative Advantage
(a) Autarky (no trade)
Computers in terms of wheat
France
1 computer =
25 days
Germany
1 computer =
20 days
Wheat in term of computers
France
1 wheat
=
0.04 days
Germany
1 wheat
=
0.05 days
(b) Germany has comparative advantage in computer production because the opportunity cost in
making computers is lower than in France ( 20 < 25)
France has a comparative advantage in wheat production because of a lower opportunity cost in
its production than Germany ( 0.04< 0.05)
(c) If Terms of Trade (TOT) is 1 computer = 22 wheat
In France 1 computer = 25 wheat
They save 3 days (wheat) if they trade with Germany.
Germany
Import good is wheat
Trading exchange is:
1 computer
=
22 wheat (days)
1 wheat
=
0.045computers (days)
In Germany domestic exchanges for the import good is:
1 wheat
=
0.05 computers
Import now is at the international prices of:
1 wheat
=
Germany saves (0.05 - 0.045) = 0.005
0.045
Question 8
Term-of-Trade-Effect
Ricardian model: export the good in which you have a comparative advantage (lower opportunity
cost)
Developing countries have a CA when it comes to the production and export of agricultural
products which serve as inputs in the manufacturing of the final good by developed countries.
Unfortunately prices for these products in the international market fluctuate (may even fall) very
often.
International trade prices for the final good which the developed countries produce using the
inputs from the developing countries usually are higher in the world market.
The term-of-trade (relative price between export and imports) for the developing countries is
often falling.
Question 9
(a)
UK
Wages £8/day
£1/$2
US
Wages
$20/day
£1/$2
Bread
2days
£16
$32
2days
$40
VCR
8days
£64
$128
6days
$120
Lamps
4days
£32
$64
2days
$40
Rugs
3days
£24
$48
2days
$40
Books
2days
£16
$32
3days
$60
£20
UK exports
£60
US exports
£20
US exports
£20
US exports
£30
UK exports
(b)
Using the export condition that is:
𝑎𝑙𝑢𝑘
𝑎𝑙𝑢𝑠
𝑊
= 𝑊 𝑢𝑠𝑒
𝑢𝑘
The wage limits in UK for the various goods are calculated as follows:
𝑊𝑢𝑘 (𝐿𝑎𝑚𝑝𝑠) =
𝑊𝑢𝑘 (𝑅𝑢𝑔𝑠) =
𝑊𝑢𝑘 (𝑉𝐶𝑅) =
𝑎𝑙𝑢𝑠 𝑊𝑢𝑠
𝑎𝑙𝑢𝑘 𝑒
𝑎𝑙𝑢𝑠 𝑊𝑢𝑠
𝑎𝑙𝑢𝑘 𝑒
𝑊𝑢𝑘 (𝑏𝑟𝑒𝑎𝑑) =
𝑊𝑢𝑘 (𝐵𝑜𝑜𝑘𝑠) =
Wage limit in UK should be between £5
𝑎𝑙𝑢𝑠 𝑊𝑢𝑠 2 20
=
=5
𝑎𝑙𝑢𝑘 𝑒
4 2
=
=
𝑎𝑙𝑢𝑠 𝑊𝑢𝑠
𝑎𝑙𝑢𝑘 𝑒
𝑎𝑙𝑢𝑠 𝑊𝑢𝑠
𝑎𝑙𝑢𝑘 𝑒
2 20
3 2
6 20
8 2
=
=
= 6.6
= 7,5
2 20
2 2
3 20
2 2
and
= 10
= 15
£ 15
(c ) Exchange rate limit
(Bread)
£16 = $40
£1 = $2.5
(VCR)
£64 = $120
£1 = $1.87
(Lamps)
£32 = $40
£1 = $1.25
(Rugs)
£24 = $40
£1 = $1.66
(Books) £16 = $60
£1 = $3.75
Exchange rate limit should be between 1.25
and
3.75 to the dollar.
Question 10
(a) Increases in wages, increase the cost of production. Initial advantages gain in the export of a
good can be lost if the increase in wages leads to increases in the price of the export good.
Increases in wages can mean losses in competitiveness.
(b) Depreciation in the value of the domestic currency implies domestic goods are now less
expensive in the world market which can lead to increases in export.
Depreciation in the value of the domestic currency also means that you are now paying more for
the same amount of foreign currency. This means imports become very expensive.
Question 11
Mercantilist: Accumulations of precious metals = Nations wealth and wellbeing.
Domestic policy: Pay lower wages
Ricardo model. Monetizing the Ricardian model implies increases in wages leads to less
competitiveness.
Lower wages leads to lower cost of production
increased competiveness and increases in
exports. This leads to increased wealth for the nation. Lower wages however leads to this
competitiveness.