Download HW2 Solution Key

HW2 Solution Key
UCDavis, 160a, Spring 2008
Ricardian Model
Prof. Farshid Mojaver
Problem 1
a. Definition 1 The opportunity cost of producing X is the amount of Y forgone to produce one
extra unit of X.
• Opportunity Cost of producing good X in the Home country: aLX/aLY = 1/(1/2) = 2 units
of Y .
• Opportunity Cost of producing good X in the Foreign country: aLX*/aLY* = (1/4)/1=1/4
units of Y .
b. • Relative price of good X at Home in autarky:
In perfect competition wages are set to price * marginal productivity of labor, thus wages
in the X and Y industries are set to
X = PX/aLX
Y = PY/aLY
As described in lecture, this implies that in a diversified perfectly competitive equilibrium, we
must have that
PX/aLX = PY/aLY
PX/PY = aLX/aLY
PX/PY =1/(1/2) =2
• Similarly for Foreign:
PX*/PY* = (1/4)/1 = 1/4
c. In order to be able draw the PPF we need to know how the available resources can be
distributed over the production of X and Y. This is given by
L = QX . aLX + QY . aLY
rewriting this expression, we get
QY = L/ aLX - (aLX /aLY)QX,
which is a linear equation with Y y-intercept L/aLY and slope aLX/aLY. So for Home
QY = L/aLY - (aLX /aLY)QX,
QY = 1000/(1/2) – (1/2)QX
QY = 2000 – 2QX
and for Foreign
QY* = L*/ aLX* - (aLX */aLY*)QX*,
QY* = 1000/1 – (1/4)/1QX*
QY* = 1000 – 1/4QX*
PPF’s Under Autarky
Problem 2
Labor
Opportunity Costs
Labor
Requirement
Endowment
aLW
aLC
PW/PC
PC/PW
Wonderland
10
5
2
1/2
40m
ROW
6
2
3
1/3
30m
a. ROW has absolute advantage on producing both wine and cheese because its
labor requirements are lower.
b. Comparative advantage means lower opportunity costs. Therefore, wonderland
has comparative advantage in producing wine and ROW has comparative
advantage in producing cheese.
c. Wonderland: 10QW + 5QC = 40; ROW: 6 QW + 2QC = 30
d.
15
Cheese
P
Cheese
8
C
10
5
C
A
4
6
A
P
2
4
Wine
Wonderland
2 3
5
ROW
Wine
e. When the world price ratio is .4 bottle wine per pound of cheese, PC/PW = .4 and
therefore, PW/PC = 2.5. In this case, the world price ratio is between these two
country’s opportunity costs, therefore, Wonderland will specialize in producing
wine (4m bottles of wine) and ROW will specialize in producing cheese (15m
pounds of cheese).
Problem 3
Consider the graph below. A is the autarky production and consumption point for this economy.
Suppose international terms of trade are represented by line P*. Show gains from trade if the
country decides to join international trade without changing its production point.
Qw
B
C
IFT
A
P*
IAut
IC
QC
Question 4
Make an argument to show that a domestic firm may lose out in international competition
even if it is the most productive producer in the world.
A domestic firm that has the highest productivity in the world may lose out in
international trade because there might be firms with even higher productivity in that
country that drive the average wages higher (i.e, US might have the most productive
apparel industry in the world but even higher productivity in wheat production drives
the wages high so that it is not cost effective produce apparel in US).
Question 5
Read the following excerpt from Adam Smith on division of labor and labor productivity
to answer the subsequent questions
http://william-king.www.drexel.edu/top/Prin/txt/Intro/Eco111g.html
1- When we speak of specialization in the Ricardian model and increased national
and international productivity do we have the Smithian model in mind?
With Ricardian specialization we mean shifting resources to sectors with
comparative advantage so we produce more with the same level of productivity.
In the Smithian model specialization increases productivity so there is an
additional source of gain from trade in his that model.
2- What does the Smithian division of labor imply on the productivity of larger
economies?
Larger economies with larger demand for everything imply more division of labor
higher levels of specialization and higher productivity. Thus larger economies are
more productive according to the Smithan model while in the Recardian model
country size does not affect productivity.
3- What is the source of gains from trade and increased productivity in the Ricardian
model?
Allocation efficiency
4- Consider a two good economy: grain and computer. They are both produced with
labor only but grain is subject to constant return to scale technology while
computer production is subject to increasing return to scale technology. Draw the
Production Possibility Frontier for this economy.
Adam Smith and gains from trade
Answer the following questions pertaining to the excerpts from Adam Smith’s Wealth of
Nations (posted on the class web page).
1- How does Adam Smith measure the contribution of any individual to national wealth?
By his/her income
2- According to Adam Smith why social interest is promoted best when individuals
pursue their self-interest?
If social interest is measured by GDP and contribution of each individual to GDP
is equal to his/her income then when individuals maximize their income by
pursuing their self interest then income and hence GDP is also maximized.
3- What are the implicit assumptions in this assertion?
a- national interest is measured by GDP
b- have competitive markets
c- self interest is followed within rules of the game
d- have good rules
4- Do you agree with the assertion that “By pursuing his own interest he frequently
promotes that of the society more effectually than when he really intends to promote
it”? Explain your thinking.
5- How does Adam Smith generalize the conclusion he gets from his example of
Domestic trade between individuals to gains from trade between nations?
Countries just like individuals can gain from specialization and trade. If each
person /nation specializes in the production of what it has some advantage then it
earns more income with which it can purchase other goods.
6- Does everyone gain from voluntary trade (discuss in absolute and relative terms)?
Generally speaking trade increases national income of every country but that does not
mean that within the country everyone is better off with the trade. Some people may
lose because of international trade. International trade may worsen the relative
position of country I terms of GDP. That is the gains from trade may be distributed
unevenly as a result some countries may feel unhappy about it even though in
absolute terms trade had made them better off.
7- What enables an individual/a nation to produce something at a lower cost?
Specialization & having a natural of acquired advantage
8- What are the sources of national advantages in trade?
Natural advantages-climate, natural resources, ect.
Acquired advantages – increase in productivity because of specialization, division of
labor, repletion of tasks and gaining more skill
9- While Great Britain can make good wine why should she import it?
Since foreigners are 30 times more productive in wine production GB has to
spend 30 times more than foreigners to produce the same wine. That is GB can
import the needed wine with 1/30th of the resources employed domestically.
10- In his example Adam Smith argues that GB can import the needed wine with 1/300th
of domestic resources. How does he come up with this figure? (Hint: assume that it
takes 30 units of resources to produces one gallon of wine in GB while in the foreign
country it takes only one. Also assume that GB can produce one yard of cloth with
only one unit of resources while in the foreign country it takes 10 units of resources.
In other words BG is 10 times more productive in cloth production and foreigners are
30 times more productive in wine production).
GB can produce one yard of cloth with 1/30th of the resources needed to produce
one gallon of wine which can be exchange with 10 gallons of wine in the foreign
country (because with the 10 unit of resources needed to produce one yard of
cloth foreigners can produce 10 gallons of wine). If via trade GB can obtain 10
gallons of wine with 1/30 of resources needed to produce one gallon of wine then
with 1/100 of resources GB can get 1 gallon of wine.
11- What are the two justifications for some level of protection of domestic industry
according to Adam Smith?
- Protection of defense related industry
- When domestic industry in taxed
12- What was the major function of the act of navigation in GB?
It restricted the kind of good that can be imported to GB and required that all the
imports to GB must be done with British ships.
13- How the act protected GB domestic industry?
The act made imports to GB more expensive by restricting imports to British
ships. The act boosted the ship industry in GB.
14- According to Adam Smith does it matter what or with home you trade?
Adam Smith praised measures that restricted trade with Holland. GB was not in war
with Holland at that time but the two countries were trading rivals. Adam Smith was
aware that such restrictions might reduce GB national income in the short run but it
saw an strategic gain in the pursuing it.
15- Why Adam Smith supports the act of Navigation despite his own argument that the
act reduces trade and the opulence of BG?
Because “defense” is “much more important that opulence”.
16- How can the defense industry benefit from this policy?
Giving monopoly of import to British ships expands shipping industry in GB which
in turn strengthens British naval power which was instrumental in furthering British
interest around the globe.
17- In addition to the defense argument made by Adam Smith do you see any other
reason for the act of navigation? Did the act actually lead to greater opulence in
addition to better defense?
The act of navigation stifled Dutch trade and industry. By limiting market access
of its main trade rival GB secured larger market for its industry and better terms
of trade. This was a strategic move on the part of GB.