1.a The relative price of producing a manufactured good can be obtained by getting the ratio of manufactured goods to agricultural goods in a particular economy. This gives us the following values for Relative Prices of Manufacturing.
|Relative Price of Manufacturing||2.5A||1.5A|
1.b. From 1a, we see that it is cheaper (in terms of sacrificed units of agricultural goods) to produce manufactured goods in the foreign country. Therefore, our trade setup is the following: Home produces agricultural goods. Foreign produces manufactured goods
This trade condition results in the combined PPF below.
The kink shows the point wherein Home exclusively produces agricultural goods and Foreign exclusively manufactures. The benefit can be seen in the expansion of the PPF. The combined PPF of both countries is outward of the individual PPFs of each country. This means that the economic capacity (measured in terms of available agricultural and manufactured goods) for each country has expanded under trade.
1.c The range of possible relative prices reflect the slopes available in the combined PPF. This means that for our system, the possible prices are the 0.4 < Pm/Pa < 0.6666666.
1.d Since Home is producing agricultural goods, the best prices for home would be when agricultural prices are highest or conversely if imported manufactured goods are the lowest. This occurs when Pm/Pa = 0.4.
1.e. If we assume that both economies are producing at maximum efficiency, then the prices of their products would be equal to the marginal costs incurred in their production. If we assume that at the point of production of these economies, labor costs would account for the price of their products. Then we can now relate the price of wages to that of the actual products. Earlier, we know that the price continuum would be 0.4 < Pm/Pa < 0.6666666. Since Foreign produces all manufactured goods and Home makes all agricultural goods, we get the following: 1.5 < Wh/Wm < 2.5. This is simply the inverse of our cost relationship.
2.a As a result of trade, the cost of fish in the local market will drop due to the availability of cheaper imported fish. Similarly, the PPF will expand outwards as the amount of fish available in the local market would increase. Because of the drop in price, the budget line would also pivot upward. As the price of chips remain constant, the budget line will pivot around the value were chips are the exclusive product purchased by the economy. As seen in the plot above, this all results in the budget line intersecting a much higher indifference curve. As higher indifference curves indicate a combination of goods which produces a higher amount of utility, we see here that opening up to trade results in the economy of Home getting a net increase in utility.
2.b. When trade is opened up, Home will tend to produce more computer chips and simply import more fish from the world market where it is cheaper. Because labor is mobile, more labor and capital inputs would go into the production function of computer chips, and consequently, less labor input would go into the production of fish. From the law of diminishing marginal returns, we know that the higher number of inputs for computer chips will lower the marginal product of both its inputs. The opposite can be said for fish production. Because it is produced at lower numbers, the average marginal product of its capital input would be much higher before trade.
2.c. With the shift towards computer chips, the quantity demanded of skilled laborers would increase. Using a supply and demand model for wages, this increase in demand would result in an increase in wages. The wages for unskilled laborers would also increase via the same method as computer chip factories demand more laborers. As the labor market is mobile, the fish industry would be forced to also increase its wage prices to prevent the migration of its laborers to the computer industry.
3.a. Foreign would have a higher no-trade relative price for autos. Compared to Home, capital resources in Foreign are much scarcer and hence, the relative price of capital compared to labor is higher in Foreign compared to home. Therefore, autos would be comparatively more expensive to produce in Foreign compared to Home.
3.b. The following plots show the PPF for both Home and Foreign. The points indicate the points where the indifference curves intersect the PPF for each country. This point would indicate the level of consumption for each country. As we can see, because of the disparity in relative abundance of resources, the Qa/Qs at Home is much higher than the Qa/Qs at Foreign. Conversely, the Pa/Ps for Home is much lower than the Pa/Ps at Foreign. Therefore, what Foreign would do is to import Autos from home (where it is much cheaper) and export shirts to Home (where it is much more expensive).
Appleyard, Field, & Cobb. (2006). International Economics (5th ed.). McGraw-Hill Irwin.