1 ricardian model consider two countries a and b labour is

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Reference no: EM13375586

1. Ricardian Model. Consider two countries: A and B. Labour is the only factor of production for goods X and Y.

Consider the following matrix of unit labour requirements.

	X	Y	Labor Endowments
Country A	a_Lx = 15	a_Ly= 3	120
Country B	a_Lx^* = 6	a_Ly^*= 2	120

a) Which country has comparative advantage and absolute advantage in producing good X?

b) What is the autarky relative price of good X for country A? For country B?

c) Draw the world relative supply curve RS for good X. Label all the axes (relative price of good X on the vertical axis and world output of x relative to y on the horizontal axis) and the relevant points.

d) Suppose that the relative demand RD for good X is given by:

(P_x/P_y) = 10 - 12 * ( ( Q_x +Q*_x) / (Q_y + Q*_y) ).

With free trade: (i) What will be the equilibrium world relative price of good X be equal to? (ii) Calculate the equilibrium wage rate w in A relative to that in B under free trade: w/w*.

2. If the world price of oil falls, what impact will this have on the welfare of an oil exporting country like Saudi Arabia? Use the Ricardian trade model assuming that Saudi Arabia is specialized in the production of oil and imports another good called "Manufactures" to answer this. You can ignore the Foreign Country and just focus on Saudi Arabia.

3. True or false? Briefly explain. "Free trade is beneficial because it rotates a country's production possibility frontier (PPF) outward."

4. In class we worked through the trade example where Home had a comparative advantage in cheese (a_lc /a_lw < a_lc* /a_lw*). The result was that world price ratio was between the autarky price ratios of the two countries. We showed for the Home country that the opening of trade resulted in the workers' real wage in terms of cheese remaining the same while the real wage in terms of wine increased. (There is no need to use diagrams to answer the questions below.)

(a) With the opening of trade what will the nominal wage W* be in the Foreign country? (You will not be able to find a numerical value here.) Briefly explain.

(b) What will happen with the opening of trade to the Foreign country's real wage in terms of cheese and wine? Briefly explain.

5. Draw the production possibility frontier for the Home country with cloth on the horizontal axis and food on the vertical axis. Suppose the economy is engaged in free trade and the free trade relative price of cloth is given.

(a) In your PPF diagram show where the economy will produce. What condition holds at that point? (Note: Do not illustrate the consumption point - just where production takes place.)

(b) Now suppose the economy's endowment of capital - the specific factor used to produce cloth - increases. In your PPF diagram, show the economy's new production possibility frontier. Briefly justify your answer.

(c) If the free trade relative price of cloth remains constant, illustrate in your diagram where production will now take place. Will production of cloth increase or decrease?

Reference no: EM13375586

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