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Consider a two countries, Portugal and England, that produce two goods, wine and cheese, with only one factor of production, Labor. In England, one unit of labor can produce 2 units of wine or 1 unit of cheese. In Portugal, one unit of labor can produce 3 units of wine or 1/2 of cheese. There are 100 units of labor in Portugal, and 100 in England. Countries share the same tastes, and there is perfect competition.
1) Fill in the following table:
Remember that the production possibilities frontier is the combination of wine and cheese that can be producedin each country, given resources (in our case, given the amount of labor).
Remember that for equilibrium we want to know how much each country is producing and consuming of each good (Hint: you will NOT be able to give a precise numerical answer.) AND the relative price of goods.
a)Suppose now that preferences are such that consumers in both countries (remember, tastes are the same) always want to consume twice as much wine as cheese. What would the autarky equilibrium be? (Now you can give me a precise number!)
(Notethat when you read “relative price of cheese” this is means “price of cheese relative to wine” or PC/PW)
Does the pattern of trade change? Does the level of production change? Do the gains from trade change?
For the gains from trade, look carefully at how the Consumption Possibilities changes with the new price.
1) If England uses all labor to produce wine, then wine production will be 100*2 = 200 units and if all labors are used to produce cheese, then total cheese will be 100*1 = 100 units.
Similarly, If portugal uses all labor to produce wine, then wine production will be 100*3 = 300 units and if all labors are used to produce cheese, then total cheese will be 100*1/2 = 50 units.
Thus, the table will look as follows -
|50/300 = 0.167
2) Absolute advantage occurs in country which produces more units with given resources. As you can see, Portugal can produce more of wine and England can produce more of cheese with 100 labors as compared to each other, then Portugal has absolute advantage in producing wine and England has absolute advantage in producing cheese.
Comparative advantage occurs when a country has lesser opportunity cost in production of a good than the other country. It is same as price of good in terms of other good (such as PW/PC and PC/PW). As you can see PW/PC (price of wiine in terms of cloth) is lesser of Portugal, then Portugal has comparative advantage in producing wine. And PC/PW is less of England, thus England has comparative advantage in producing cheese.
3) Use the given coordinates of cheese and wine for both country to draw PPF curves-
England (200,0) and (0,100)
Portugal (300,0) and (0,50)
Wine is placed at X axis and cheese is placed at Y axis
4) In autarky equilibrium, both countries will produce any combination given at their respective PPF curves. The relative price equals PW/PC and PC/PW for each country given in the above table.
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