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Answer To Problem 1: LC LW LC LW C W A A P P A A

1. While absolute advantage matters, it is comparative advantage that determines whether free trade benefits a country. Even if wages differ between countries, both can gain from trade as long as each has a comparative advantage in producing some good. 2. In this example, the home country has a comparative advantage in good C and the foreign country in good W, so each specializes and gains from trading based on their comparative advantages, despite the home country having a higher wage. 3. Changes in labor supply (L*) may change comparative advantages, but as long as one exists, specialization and trade according to comparative advantage allows gains for both countries.

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109 views1 page

Answer To Problem 1: LC LW LC LW C W A A P P A A

1. While absolute advantage matters, it is comparative advantage that determines whether free trade benefits a country. Even if wages differ between countries, both can gain from trade as long as each has a comparative advantage in producing some good. 2. In this example, the home country has a comparative advantage in good C and the foreign country in good W, so each specializes and gains from trading based on their comparative advantages, despite the home country having a higher wage. 3. Changes in labor supply (L*) may change comparative advantages, but as long as one exists, specialization and trade according to comparative advantage allows gains for both countries.

Uploaded by

Chiew Jun Siew
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Answer to Problem 1

1. Free trade is beneficial only if a country is strong enough to stand up


to foreign competition.
[Hint: Show that it is not the absolute advantage but the comparative
advantage that matters.]

2. Trade exploits a country and makes it worse off if its workers receive
much lower wages than workers in other nations.
[Hint: Show that even if there are wage differentials, countries can
gain from trade as long as they have a comparative advantage.]
Suppose that a LC = 1, a LW = 2, aLC = 3, aLW = 2, PC = PW = 1. It
a
follows that aaLW
LC
< PPWC < aLC . Hence, Home country specializes in
LW
production of C and Foreign country in W and they trade each good
based on comparative advantage. There will be gains from trade
even though w = aPLC
C
> w = aPWLW .

3. Note that L does not change the comparative advantage. However,


a
L may increase so much that aaLWLC
< PPWC = aLC (See Figure 3, Lecture
LW
Note 1). In this situation, home country strictly prefers producing
QC to QW but the foreign country is indifferent. To find out how
much the foreign country will produce either of the goods we have
to specify the utility function.

4. Competitive labor market implies that WC = aPLC C


and WW = aPLW W
.
Without trade perfect labor mobility implies that wages in the two
sectors must be equal, i.e. aPLC
C
= aPLW
W
or PPWC = aaLW
LC
. With trade, each
country can specialize its production in the good it has a comparative
advantage in and trade for the other good. In this case, the relative
price need not be equal to the opportunity cost.

5. You must make your own case by providing evidence (data, obser-
vation, survey, etc.) and argue based on the model. Tell your own
story!

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