International Trade: Comparative Advantage, Productivity and Relative Prices

Two-Country, Two-Goods Model

Question 1

Consider a two-country, two-goods world. Trade is based on comparative advantage. You are

given the following information (which applies to the whole question, unless otherwise stated):

? One labour can produce 20 toasters (T) or produce 40 ovens (O) in Home (H); while one unitof foreign labour can produce 25 units and 50 units of toasters and ovens respectively.

? The labour endowment in Home is 500, which is one-hundred units more than Foreign.

? The free-trade relative price of toaster is the average of the countries’ autarky relative prices.

? Both countries agree to trade 3400 toasters.

Note: Keep your answer to 2 decimals places if needed.

a) Is there any gain from trade? Yes/No, explain.

b) Suppose a new production technology is available for ovens such that the level ofproductivity increases by 10% in Home. Compute the free-trade relative price of toaster.Find the production and consumption bundles for Home.

c) (Continued from part b) Suppose the new production technology for ovens is also availableto Foreign such that the level of productivity increases by 4% in Foreign. Redo part (b).

d) Show your answers in parts (b) & (c) in a well-labeled diagram (label toasters on thehorizontal axis). Also, remember to identify Home’s levels of exports and imports, and labelthe slopes of the PPFs and budget constraints. No need to include the indifference curvesand no written explanation is needed.