Question 4 Consider a Ricardian model with two countries of

Question 4: Consider a Ricardian model with two countries of equal size, the US and Ecuador, producing two goods, bananas and machines. Suppose the unit-labor requirements are: US = 2, aLM Let the US have 3200 workers and Ecuador have 400 workers. (1 pt) Which country has the absolute advantage in bananas! (4 pts) Which country has the comparative advantage in bananas? Show your calculations and explain why? (no more than 50 words please) (4pts) Calculate each country\'s autarky price ratio PB/PM? Please show your calculations. (2 pts) What are the patterns of trade in free trade? (2 pts) How much of each good would Ecuador and US produce in free trade if complete specialization occurred? (2 pts) Specify plausible free trade terms of trade (relative world prices) (6 pts) Suppose the world relative price after trade is PB/PM -2. Please show using Ecuador\'s PPF and Indifference curves if the country would gain from trade. 1. ii. iii. iv. v. vi. vii.

Solution

Answer : i. Absolute advantage shows the differences between the input of labour units in two or more countries for the same good production. Country with the highest labour endowment is called the country has absolute advantage in producing a good than others.

From the given information it is clear that the country US has the absolute advantage in bananas. Because US has 3200 units of labour endowment and Ecuador has 400 units of labour endowment.

ii. Comparative advantage shows the differences between the opportunity costs in producing same good. A country with higher opportunity cost is called that the country has comparative advantage.

In case of banana production,

Labour capacity to production in US = 8

Labour capacity to production in Ecuador = 4

Opportunity cost in US = 3200 × 8 = 25600

Opportunity cost in Ecuador = 400 × 4 = 1600

Therefore, the country US has the comparative advantage in producing bananas because of higher opportunity cost.

iii. In autarky the relative price ratio is equal to the relative cost ratio.

Autarky price ratio in US ,

P_B / P_M = ( 8 × 3200 ) / ( 2 × 3200 ) = 4/1 = 4.

Autarky price ratio in Ecuador,

P_B / P_M = ( 4×400 ) / ( 4×400 ) =1.

iv . In free trade if a country has higher opportunity cost than others in producing a good then that country export it\'s products to the lower opportunity cost country in terms of importing other good from that country.