Absolute Advantage and Comparative Advantage
In order produce 1 unit of butter Home country requires 1/5 hours of labor while foreign country requires 1 hours of labor for the same. As home country requires lesser labor hours to produce butter, home country has an absolute advantage in producing butter (Feenstra 2015). For cloth, home country requires 1 hours of labor to produce 1 unit. For producing same, foreign country requires 1/3 hours of labor. Therefore, foreign is able to produce cloth with a lesser labor hour. Foreign country thus enjoys an absolute advantage in production of cloth.
Answer b
Home has an absolute advantage in producing butter while foreign has an absolute advantage in production of cloth. Therefore, going by the theory of absolute advantage, home should specialize and export butter while foreign should specialize and export cloth (Helpman and Razin 2014). In order to produce 5 units of butter, home requires to use (1/5 * 5) = 1 hours of labor. Production of 3 units of cloth in home country would require (1*3) = 3 hours of labor. Home country thus saves (3 – 1) = 2 hours of labor. Using this 2 hours of labor Home country could produce additional (2*5) = 10 units of butter. Home country thus gain 2 hours of labor or additional 10 units of butter by involving in trade of 5 units of butter in exchange of 3 units of cloth.
For Foreign country, production of 3 units of cloth requires (1/3*3) = 1 hours of labor. Production of 5 units of butter requires (1*5) = 5 hours of labor. Foreign thus saves (5 – 1) = 4 hours of labor. Using this 4 hours of labor, Foreign country can produce (4*3) = 12 units of cloth. Foreign country thus gains 4 hours of labor or 12 units of cloth for involving in such exchange relation (Leamer and Stern 2017).
Answer c
Home uses 1/5 hours of labor to produce 1 unit of butter. Therefore, to produce 5 units of butter home spends (1/5*5) = 1 hour of labor. Home needs to spend 1 hour of labor to produce 1 unit of cloth. In order to produce 6 units of cloth Home therefore needs to use 6 hours of labor. However, by involving in trade with Foreign, Home country can get 6 units of labor by using only 1-hour labor instead of instead of spending 6 hours of labor (Schachter 2017). Home country thus saves (6 – 1) = 5 hours of labor. Home country can use this 5 hours of labor to produce butter in which it has an absolute advantage (Chacholiades 2017). This 5 hours of labor can be used to produce (5*5) = 25 units of butter. The gain to Home country thus can be measure in terms of 5 hours of labor or 25 units of butter.
Foreign use 1/3 hours of labor to produce 1 unit of cloth. 6 units of cloth production in Foreign country thus requires 2 hours of labor. To produce 1 unit of butter Foreign country needs 1 hour of labor. Production of 5 units of butter thus require use of (1*5) = 5 hours of labor. By involving in the exchange relation, foreign country thus can get 5 units of butter by spending only 2 hours of labor instead of 5 hours of labor. Foreign country thus saves (5 – 2) = 3 hours of labor. The 3 hours of labor thus can be used to produce additional (3*3) = 9 units of labor. The gain to foreign country thus can be expressed as 3 hours of labor or additional 9 units of cloths (Krugman, Obstfeld and Melit 2015).
Specialization and Gains from Trade
Answer c
Answer 2: The Ricardian model
Answer a
Home has 1000 hours of labor. Home produces 1 motorbike using 5 hours of labor. Using 1000 hours of labor Home country can produce maximum (1000/5) = 200 motorbikes. Home produces 1 Skateboard using 2 hours of labor. Therefore, using all the 1000 hours of labor, Hone country can produce maximum (1000/2) = 500 Skateboard (Holmes and Stevens 2014). Therefore, the Production Possibility Frontier for Home is given below
Foreign has 1200 hours of labor. Foreign uses 3 hours of labor to produce 1 motorbike. Using 1200 hours of labor Foreign can produce (1200/3) = 400 motorbikes. In order to produce 1 Skateboard, Foreign uses 3 hours of labor. Henceforth, using all the available labor hours Foreign can produce (1200/3) = 400 units of labor (Neary 2016). The Production Possibility Frontier for foreign country is therefore is given below
In autarky, relative price of the produced goods equals to the involved opportunity cost of production. The rationale, behind this is with positive demand for both goods, corresponding to equilibrium cost of purchasing the goods needs to be equal with cost to produce the goods (Burley 2017). Home requires 5 hours of labor to produce 1 motorbike and it requires 2 hours of labor to produce 1 skateboard. The relative price of motorbikes in terms of skateboard in Home thus equals
The relative price of motorbikes in terms of skateboard in Foreign equals
|
Motorbikes |
Skateboards |
|
|
Home |
5 (hours) |
2 (hours) |
|
Foreign |
3 (hours) |
3 (hours) |
|
Opportunity cost |
Motorbikes |
Skateboards |
|
Home |
5/2 = 2.5 |
2/5 = 0.4 |
|
Foreign |
3/3 =1 |
3/3 = 1 |
The production of 1 Motorbike in Home country requires sacrifice of 2.5 units of Skateboard. In Foreign country the opportunity cost of Motorbikes in terms of Skateboards is 1. Because of lower opportunity cost, Foreign country should specialize in production of Motorbike. The opportunity cost of Skateboard in terms of Motorbikes in Home equals 0.4 while the same in foreign equals 1. Home country thus has a comparative advantage in production of Skateboard and thus should be specialize in skateboard.
The relative price of skateboard in Home country is equivalent to 2/5 while that in Foreign country is 1. The world relative price of skateboard thus must lie between 2/5 and 1 (Borkakoti 2017). The relative price of Skateboard in terms of Motorbikes under free trade is given as 4/5. As this lies between the autarky relative price ratio in Home and Foreign, both the country will specialize in goods in which they have a comparative advantage.
The total labor endowment in Home country is given as 1000 hours. That is LH = 1000. The unit labor requirement for Skateboard (aLS) is 2 hours. Therefore, using all the labor hours Home country can produce total of
Given the world relative price ratio,
1 unit of Skateboard can be exchanged with 4/5 motorbikes
Therefore, 500 unit of Skateboard can be exchanged with 4/5*500 = 400 motorbikes
Before trade,
All the labor hours need to be allocated between Motorbikes and Skateboard.
When S = 0, M = 200
When M = 0, S = 500
After trade,
Home can exchange 500 motorbikes for 400 Skateboards. Home country thus now has a larger availability of Skateboards.
Determining Relative Prices
The total labor endowment in Foreign country is given as 1200 hours. That is LF = 1000. The unit labor requirement for Motorbike (aLM) is 3 hours. Therefore, using all the labor hour Foreign country can produce total of
Given the world relative price ratio,
1 Motorbike can be exchanged with 5/4 Skateboard
Therefore, 400 Motorbike can be exchanged with 5/4*400 = 500 motorbikes
Before trade,
All the labor hours need to be allocated between Motorbikes and Skateboard.
When S = 0, M = 400
When M = 0, S = 400
After trade,
Foreign can exchange 400 skateboard for 500 motorbikes. Foreign country thus now has a larger availability of Motorbikes.
Answer 3: The Ricardian model
Answer a
In order to produce 1 unit of X, economy H requires 6 unit of labor. Economy F on the other hand requires 4 unit of labor for producing 1 unit of X. A country is said to have an absolute advantage over another country if it can produce a good at a relatively lower absolute cost compared to other. Here, the economy F requires less unit of labor to produce 1 unit of X. The economy F thus has an absolute advantage relative to economy H for producing X. So far as production of Y is concerned, economy H needs to employ 12 unit of labor to produce 1-unit Y. Economy F needs to employ 2 units of labor to produce 1 unit of Y. The economy again requires less unit of labor to produce 1 unit of Y (Helpman et al., 2017). The economy F therefore enjoys a comparative advantage in the production of Y. The discussion thus suggests that economy F enjoys an absolute advantage in producing both the goods X and Y.
The determination of comparative advantage depends on the estimation of opportunity cost. A country is said to has a comparative advantage over another country if it requires a relatively lower opportunity cost in production of one good compared to other (Co?ar and Fajgelbaum 2016). The opportunity cost involved in production of X and Y in the economy H and F is given in the following table.
|
Opportunity cost |
X |
Y |
|
H |
6/12 = ½ |
12/6 = 2 |
|
F |
4/2 = 2 |
2/4 = 1/2 |
Opportunity cost is the cost of sacrificing one good to enjoy additional unit of some other. For country F, for producing 1-unit X, ½ unit of Y needs to be sacrificed. The opportunity cost of 1 unit of X is thus ½ unit of Y. For country F, production of 1 unit of X involve sacrifice of 2 units of Y, which is the opportunity cost of X. Economy H therefore has A comparative advantage in X following the lower opportunity cost (Burstein and Vogel 2017). For producing Y, economy H needs to sacrifice 2 units of motorbikes while the economy sacrifices only ½ unit of X. Country F thus has a comparative advantage in production of Y
Answer b
The economy H has 2400 units of labor. Using this labor H can produce maximum (2400/ 6) = 400 units of X and (2400/12) = 200 units of Y. The production possibility frontier for economy H is given in figure 3
Production Possibility Frontier
The economy F has 1800 units of labor. Using this labor H can produce maximum (1800/ 4) = 450 units of X and (1800/2) = 900 units of Y. The production possibility frontier for economy F is given in figure 3
The autarky equilibrium price equals the relative price in both the nation (Baier, Bergstrand and Feng 2014). The autarky equilibrium price in H is
The autarky equilibrium price in F is
Answer c
The feasible world price ratio lies between autarky equilibrium price of the two nation. Given the autarky equilibrium price in H and F equals ½ and 2 respectively, the world price ratio must lie between this two.
Answer d
Pattern of trade depends on either absolute or comparative advantage of nations. Here, country F has an absolute advantage for producing both X and Y. Therefore, no trade pattern is explained by absolute advantage. Country X has a relatively lower opportunity cost for X in terms of Y. The economy H sacrifices ½ unit of Y for producing 1 unit of X. The economy F on the other hand sacrifices 2 units of Y. The lower opportunity of X in terms of Y in H, offers the economy a comparative advantage (Foxa and Sanchez 2018). As the economy H enjoys a comparative advantage in production of X, it should specialize and export X.
Answer e
In the Ricardian model, trade leads to equalization of output prices in two nations. Wages or real return to inputs however are not equalized. This is because wage represents the labor productivity which is different in the two trading nations. Trade increases the price of exportable good causing wage to rise in that sector, but does not equalize return to factors. Equilibrium output price of the traded goods is determined from the world relative price and world relative supply. Input prices however are not determined from the relative demand and relative supply (Dur, Baccini and Elsig 2014).
Suppose, W denotes wage in Home (H) country and W* denotes that in Foreign (F).
In each country, wage is determined from labor productivity.
As discussed above Home country specializes in X while Foreign country specializes in Y.
Hence, trade does not equalize the real return to Home and Foreign
References
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