Homework 2 UCDavis, 160a, Spring 2008 Ricardian Model Prof. Farshid Mojaver Problem 1: Consider trade between two countries, Home and Foreign. Denote values associated with Foreign using asterisks. Each country is capable of producing consumer goods X and Y. Each country is endowed with 1000 worker hours (L=1000=L*). The table below gives the unit input requirement in each country for each good: Home Foreign X aLX= 1 aLX*= 1/4 Y aLy= 1/2 aLy*= 1 a. What is the opportunity cost of producing good X in the Home country? In Foreign? b. Assume that each consumer likes to consume some of each good. What is the relative price of good X at Home in autarky? In Foreign? c. Draw Home's production possibility frontier (PPF); put output of good X on the horizontal axis and output of good Y on the vertical. Be sure to label intercepts and axes, and indicate the slope. Do the same for Foreign. Problem 2: You are given the information shown in the table about the production relationship between Wonderland and the rest of the world and use the standard Ricardian assumptions: Wonderland Rest of the World Labor Hours per Bottle of Wine 10 6 Labor Hours per Pound of Cheese 5 2 Wonderland has 40 million labor hours in total and the rest of the world has 30 million labor hours in total per year. a. Which country has absolute advantage in wine? In cheese? b. Which country has comparative advantage in wine? In cheese? c. Graph each country’s PPF. Use indifference curve to show the no-trade equilibrium (label as point A) for each country. (Suppose Wonderland consumes 4 million pounds of cheese and the rest of the world consumes 6 pounds of cheese). d. When trade is opened between Wonderland and the rest of the world, what the pattern of trade is? If the world price ratio is 0.4 bottle of wine per pound of cheese (Be careful this is not Pw/Pc but Pc/Pw), what happens to production in each country? (Label the new production point in each country as point P) e. Suppose that 2 million bottles of wine and 5 million pounds of cheese are traded. Show the consumption of each good in each country graphically using indifference curve (label the consumption point C)? 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 A P* IAut QC Question 4: Make an argument to show that a domestic firm may lose out in international competition even if it is the lowest cost producer in the world. 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? 2- What does the Smithian division of labor imply on the productivity of larger economies? 3- What is the source of gains from trade and increased productivity in the Ricardian model? 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 Read excerpts from Adam Smith’s Wealth of Nations (posted on the class web page) to answer the following questions. 1- How does Adam Smith measure the contribution of any individual to national wealth? 2- According to Adam Smith why social interest is promoted best when individuals pursue their self-interest? 3- What are the implicit assumptions in this assertion? 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? 6- Does everyone gain from voluntary trade (discuss in absolute and relative terms)? 7- What enables an individual/a nation to produce something at a lower cost? 8- What are the sources of national advantages in trade? 9- While Great Britain can make good wine why should she import it? 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). 11- What are the two justifications for some level of protection of domestic industry according to Adam Smith? 12- What was the major function of the act of navigation in GB? 13- How the act protected GB domestic industry? 14- According to Adam Smith does it matter what or with home you trade? 15- Why Adam Smith supports the act of Navigation despite his own argument that the act reduces trade and the opulence of BG? 16- How can the defense industry benefit from this policy? 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?