Week 2 (7) Trade and Comparative Advantage Chapter 3

Problem set

Exercise 2.1
Assume there are just two countries in the world, i.e. the European Union (EU) and the Rest of the World (RW). Both countries produce and consume 2 products: bicycles (b) and apples (a). Per bike, the EU puts in 3 hours of labour while the RW puts in 5. Per ton of apples, the EU needs 2 hours v. the RW 1 hour of labour. A further given is that the EU has 2400 hours of labour available v. RW 1600. The world relative demand has the following form: demand for bikes/demand for apples = price of apples/price of bikes.
Please answer the following questions:
a. How high are the opportunity costs of a bike in the EU and the RW in the absence of
A further given is that country A has a relatively large amount of labour available while country B has a relatively large amount of capital.

a. Draw the production possibility curve of country A and B and explain why they look the way they do. X requires relatively more K Y requires relatively more L [pic] For country A (large labour availability) the above graph illustrates: The light grey straight lines are the isocost lines representing different combinations of capital and labour with the same total cost. The isoquant shown with the blue curve depicst different combinations oc capital and labour yielding the same level of production for a particular good (Brakman p74). Because the country is labour abundant; meaning generally that labour’s cheaper: gives (w/r)0 >(w/r)1; this implies that the isocost line will rotate counter clockwise, shifting the point of tangency with the isoquant to point A1.

[Graph missing see Brakman p77 figure 3.4a]

For country B the Graph look similar to the one in country A however, the isocost line shifts clockwise as the country is more capital intensive.

b. Imagine the relative demand for both products is equal in the two countries and that there is no trade between the countries. Will the relative price of product X compared to product Y be