Exercise 1 Exercise 2 Exercise 3

International Trade Problem Set #2

Universität Bern

March 15, 2021

Slides by Armando Näf / Larissa Wäfler

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Exercise 1 Exercise 2 Exercise 3

Exercise 1

Consider a Ricardian model with two goods (food and clothing) and two countries (home and foreign).
Units of labor needed to produce one unit food and clothing respectively are given by αLC = 4, αLF = 2
for the home country and by α∗LC = 5, α∗LF = 3 for the foreign country.

a) Determine the absolute and comparative advantage.

I Absolute advantage:
I Clothing: Home country
I Food: Home country
I Comparative advantage:
I Clothing: Foreign country
I Food: Home country

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Exercise 1
b) Draw the country’s PPF. Determine relative prices under autarky. Draw any reasonable indifference curve
and show consumption and production under autarky.
I PC
Relative Price Home: PF
=2
P
I Relative Price Foreign: PC = 53
F

Figure: Home Figure: Foreign

Food

Food
Clothing Clothing
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Exercise 1
c) If the two countries open up to trade, in which range will the relative price be?
I PC
Under autarky the price in the home country is given by PF
= 2, and the price in the foreign
PC
country is given by PF
= 53 .
5 PC
I Therefore under free trade the price must lie in between: 3
≤ PF
≤2

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Exercise 1
d) Draw consumption and production of the home country under free trade. Show imports and exports of
the home country.
I The relative price of food is higher under free trade (or equiv. the relative price of clothing is lower)
and thus the home country will fully specialize its production on food.

Figure: Home

Food
P

A’
A

Pc /Pf

M PPF Clothing
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Exercise 2

Consider the Ricardian model with two goods (food and clothing) and two countries (A and B). Labor
units needed to produce one unit of food or clothing respectively are given by αA A
LF = 1, αLC = 2 for
B B
country A and by αLF = 3, αLC = 3 for country B. Suppose trade between the two countries occurs at
PF
prices of PC
= 32 .

a) Which country produces which good(s)?

I Country A has a comparative advantage at producing food (equiv. country B has a comparative
advantage at producing clothing) and will therefore produce only food (only clothing).

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Exercise 2

Country A: αA A
LF = 1, αLC = 2
B
Country B: αLF = 3, αB
LC = 3

A
w
b) Coumpute the relative wage rate w B . In which country is the wage higher?
I In the Ricardian model, the wage within a country is the same in both sectors and it is equal to the
value of the marginal product of labor.
I Assumption of labor mobility across sectors: implies the property that wages are the same in
both sectors
I Assumption of perfect competition: implies the property that wages (marginal cost) are
equal to the value of the labor’s productivity (marginal benefit)
I Country A: PF = w A · αA
LF
I Country B: PC = w B · αB
LC
A P α
w F LC 2 3
I Rearranging terms we get: w B = PC αLF = 3
· 1
=2
I In country A there will be a higher wage.

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Exercise 2

Country A: αA A
LF = 1, αLC = 2
B
Country B: αLF = 3, αB
LC = 1

c) Suppose country B increases its productivity in the production of clothing such that αB
LC drops to 1.
wA PF
Determine the new relative wage wB
. Assume that the relative prices PC
remain unchanged.
I Still there is perfect competition which implies that marginal costs must be equal to marginal
benefits.
I Production patterns stay the same and both countries continue to produce the same goods.
Assuming that the price will also remain the same we find the following:
I Country A: PF = w A · αA
LF
I Country B: PC = w B · αB
LC
B
wA PF αLC 2 1 2
I Rearranging terms we get: wB
= P C αA
= 3
· 1
= 3
LF
I Now there will be a higher wage in country B.

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Exercise 2

Country A: αA A
LF = 1, αLC = 2
B
Country B: αLF = 1.5, αB
LC = 1.5

d) Suppose country B’s productivity doubles in both industries, i.e., αB B

LF = αLC = 1.5. Determine the
wA
comparative advantage of the two countries and find the relative wages wB
. Assume that the relative
PF
prices PC
remain unchanged.
I The comparative advantage remains unchanged, country A is still relatively more productive in the
food sector and country B in the clothing sector.
I Production patterns stay the same and both countries continue to produce the same goods.
Assuming that the price will also remain the same we find the following:
I Country A: PF = w A · αA
LF
I Country B: PC = w B · αB
LC
B
wA PF αLC 2 1.5
I Rearranging terms we get: wB
= P C αA
= 3
· 1
=1
LF
I Now the wages are the same in both countries.

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Exercise 2

Country A: αA A
LF = 1, αLC = 2
B
Country B: αLF = 3, αB
LC = 3

e) Suppose a third country which is a large agricultural producer enters the world market. The world market
P
price of food drops to PF = 14 . What is the production pattern of country A and country B now?
C
A
w
Determine relative wages w B.
I At such a low price of food, both countries will start producing only clothing (realize that the
autarky price of food at which the countries are indifferent between producing one or the other
good is higher in both countries).
I Perfect competition will imply that marginal costs are equal to marginal profit
I Country A: PC = w A · αA
LC
I Country B: PC = w B · αB
LC
B
wA PC αLC αB
LC 3
I Rearranging terms we get: = = =
wB P C αA αA 2
LC LC
I Wages in country A are higher because labor productivity in country A is higher in the sector of
clothing than in B (absolute advantage).
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Exercise 1 Exercise 2 Exercise 3

Exercise 3

Consider the Ricardian model with two goods (food and clothing) and two countries (home and foreign).
Labor units needed to produce one unit of food or clothing respectively are given by αLF = 2, αLC = 1
for the home country and by α∗LF = 1, α∗LC = 2 for the foreign country. Total labor units are given by
L = 500 in the home country and L∗ = 1000 in the foreign country. The world consists only of the two
countries.

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Exercise 3

Home country: αLF = 2, αLC = 1 ; L = 500

Foreign country: α∗LF = 1, α∗LC = 2 ; L∗ = 1000

a) Draw the PPF of the world with clothing on the X-axis an food on the Y-axis.

Food
αLC
1250 αLF
= 21

1000

α∗
LC =2
α∗
LF

500 1000 Clothing

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Exercise 3

Home country: αLF = 2, αLC = 1 ; L = 500

Foreign country: α∗LF = 1, α∗LC = 2 ; L∗ = 1000

b) Draw the world supply curve for clothing with the amount for clothing on the X-axis and the relative price
P
of clothing ( PC ) on the Y-axis.
F

PC /PF

2 = α∗
LC
/α∗
LF

1/2 = αLC /αLF

500 1000 Clothing

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Exercise 3
Home country: αLF = 2, αLC = 1 ; L = 500
Foreign country: α∗LF = 1, α∗LC = 2 ; L∗ = 1000

c) Draw the relative wages in the home country and the foreign country in dependence of the relative price
P
of clothing. Draw the diagram with PC on the X-axis and ww∗ on the Y-axis.
F

w /w ∗

2 = α∗
LC
/αLC

1/2 = α∗
LF
/αLF

1/2 2 PC /PF

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Exercise 3

Home country: αLF = 2, αLC = 1 ; L = 1000

Foreign country: α∗LF = 1, α∗LC = 2 ; L∗ = 1000

d) Suppose the home country experiences an immigration wave and L increases from 500 to 1000. What
happens with the comparative advantage? How do relative wages ww∗ and the absolute wages in the home
economy (w ) react to the immigration wave?
I The comparative advantage is based on the relative productivity of the two countries and does not
depend on the size of the country. Thus, the home country still has a CA in producing clothing and
the foreign country still has a CA in producing food.
I Since the countries are now of equal size, relative world prices will lie between the autarky prices of
Foreign
PCHome P
C
= 0.5 and = 2. We move from the case of imperfect specialization to the case of
P Home P
Foreign
F F
perfect specialization: the home country now only produces clothing and the foreign country now
only produces food.

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Exercise 3
d) Suppose the home country experiences an immigration wave and L increases from 500 to 1000. What
happens with the comparative advantage? How do relative wages ww∗ and the absolute wages in the home
economy (w ) react to the immigration wave?
∗
w PC αLF PC 1 PC
I Relative wages are computed as: w∗
= PF αLC
= PF
· 1
= PF
PC PC
I
PF
decreases from 2 to PF
∈ (0.5, 2), implying that relative wages decrease.
P P
I Absolute wages in the home economy are determined by: w = α C = 1C = PC
LC
I We know that relative prices have changed due to the immigration wave but we do not know how
the absolute price PC has changed. Thus, we cannot make a clear statement about the change in
absolute wages.
I Important: The change in relative wages (and in absolute wages) only happened because we moved
from imperfect spezialization to perfect specialization but had nothing to do with the increase in
workers per se.

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