HW3 Answers
1. There is no need to draw graphs for this question: (10 points)
a. In the neo-classical model, what is the main basis for trade?
Differences in autarky relative prices forms the main basis for trade in the neoclassical model.
This can result when countries with same production possibility frontiers have different tastes or
when countries with similar tastes have different production possibility frontiers.
b. If the home country has a comparative advantage in good Y, what is the relationship between
the relative price of good X in the two countries?
(Px/ Py)Home > (Px/ Py)Home
Good X is relatively more expensive at home.
2. Suppose that two countries (Country I and Country II) have identical increasing-opportunitycosts production-possibilities frontiers (PPFs). Illustrate and carefully explain why, under
certain conditions, the two countries can have an incentive to trade with each other. (30 points)
ICA
(PX/PY)A
Y
A
B
(PX/PY)B
ICB
X
Differences in tastes in two countries will result in different relative prices of X in the two
countries. In the above graph, country A has a preference towards good Y while country B has a
preference towards X. Hence the relative price of X in country B is higher than in country A
resulting in a basis for trade. Country A has a comparative advantage in good X while country B
has a comparative advantage in good Y. Both these countries can attain a higher indifference
curve when they trade.
3. Suppose that two countries, in a situation where they each have an increasing-opportunitycosts production-possibilities frontier (PPF), have identical tastes and preferences (demands).
Illustrate and carefully explain why, under certain conditions, the two countries can have an
incentive to trade with each other. Why can they gain from trade? (30 points)
If the two countries have two different production possibility frontiers, then the relative price of
1
good X will be different in the two countries. In the graph below, the relative price of good X is
higher in country A and this forms a basis for trade between the two countries. Thus, country A
will export Y.
Y
Country A’s PPF
(PX/PY)A
(PX/PY)B
Country B’s PPF
X
4. a. Draw offer curves for a two country-two good case to show a point of excess demand for
good Y using the relative price line. Is the relative price of X higher or lower than the TOT? (10
points)
Excess demand for good Y
Px/Py TOT*
OC for I
OC for II
Y
I’s imports
II’s exports
I’s exports, II’s imports
X
2
At a terms of trade of Px/Py > TOT*, there is an excess demand for Y (and an excess supply of
X). The relative price of X will fall till TOT* is attained.
b. In a separate graph, show how the TOT is affected if there is an increase in demand for good
X in country I with everything else remaining constant. (10 points)
An increase in domestic demand for good X will result in a decrease of “X” offered by country I
resulting in a higher relative price of X (TOT)
TOT ** TOT*
OC for I
OC for II
Y
I’s imports
II’s exports
I’s exports, II’s imports
X
3
c. If the income effect or the terms-of-trade effect is strong and dominant, how will a country
respond when its TOT rises? Explain using a graph. (10 points)
TOT2
TOT1
OC
Y
I’s imports
II’s exports
I’s exports, II’s imports
X
An increase in TOT will increase the imports of Y and decrease the exports of X. This is defined
in the backward bending portion of the OC where the income effect outweighs the substitution
and production effects of a rising TOT.
4