International Cheese and Wine Trade - Assignment Example

Institution : xxxxxxxxxxx Title : xxxxxxxxxxx Tutor : xxxxxxxxxxx Course : xxxxxxxxxxx @2013 Exercise one (The Recardian model) 1.1) According to the Ricardian model, it is assumed that cost can be measured in terms of labor hours. It can therefore be noted that the home country utilizes less labor hours in the production of both cheese and wine as compared to the foreign country, thus having an advantage in production of both cheese and wine. However, the home country stands to benefit more if it specializes in the production of goods in which it has greater comparative advantage. Therefore, in order to determine the country that have a comparative advantage in the production of cheese and wine, it is essential to calculate the cost ratios of producing both cheese and wine. The cost ratios of producing cheese can be illustrated as follows. Home country Foreign country Cheese Wine Cheese Wine 2/3 > 0.5/2 3/2 < 2/0.5 0.67 > 0.25 1.5 < 4 From the above table, for home country, the difference in cost or the comparative advantage is greater in wine production, that is, (4-0.25) =3.75, than in cheese production, that is (1.5-0.67) =0.83. Therefore home country has a comparative advantage in wine production. Foreign country on the other hand has a comparative advantage in cheese production. This is because its comparative disadvantage is lesser than that in wine production. 1.2) Both the home and foreign countries do not maximize their utility welfare at autarky. This is because the point of equilibrium for home country and foreign countries is at the center of the curve. It therefore implies that the amount of cheese and wine produced in both countries will be less than when comparative advantage is taken into account by the home and foreign countries. From the graph, it is clear that under specialization the maximum amount of wine the home country can produce is 12 units. Therefore, in case the home country concentrates in producing both wine and cheese, the total amount of wine and cheese produced will be less. The same applies to the foreign country. 1.3) From the graph, it is clear that with trade, the home country will maximize its consumption by consuming 12 units of wine and one unit of cheese. The indifference curve will shift to the left until its tangent to the consumption possibility frontier as shown in the above graph. 1.4) From the graph, without the consumption patterns, it can be said that both the home and foreign countries would be interested in taking advantage of the prevailing comparative advantage. Therefore, since both countries have decided to produce at optimum by specializing in what they are best at, there is clear illustration that the two countries are gaining from trade. That is, the pattern of trade clearly indicates that the two countries gain from trade when comparative advantage is taken into account. The home country will produce 24 units of wine and consume 12 units, thus exporting 12 units of wine to the foreign country. Since it consumes 1 unit of cheese, it will import it from the foreign country. With specialization, foreign country capacity to produce is 2 units. This therefore implies that by exporting one unit and importing 12 units of wine, its consumption is one unit of cheese and 12 units of wine. The consumption point of the foreign country is shown below. From the above graph, point F is the foreign country consumption point. It is also important to note that with the prevailing situation in the home country, the world price of cheese will be impacted. The impact will be downwards, that is the world price will fall. The fall in world price is due to the demand and supply balance in and the excess supply from the home country. The value of exports in the home country is 12 units of wine, while the value of exports in the foreign country is a unit of cheese. There is a gain from trade since without trade the home country would have produced 1.5 units of cheese and 12 units of wine. However, with trade the home country produces 24 units and the foreign country produces 2 units of cheese. The total production therefore is 26 units, thus a gain in trade. 1.5) Point F cannot be the consumption equilibrium point after trade. This is because, point F lies above both the PPFs of the home country and foreign country. That is, point F is much above the home country’s maximum possible output of cheese. Likewise, it is much above the foreign country’s maximum possible output of wine. Exercise two (Heckscher-Ohlin Model) 2.1) Let us take Italy as the home country and France as the foreign country. Italy is land abundant and since food is produced by land intensive methods, then, Italy will produce more food as compared to television. On the other hand France is capital abundant and since television is produced by capital intensive, then, more television will be produced by France as compared to food. This can be illustrated using production possibility frontiers as follow; Italy or home country France or foreign country The above PPFs can be drawn in the same graph so as to effectively illustrate how domestic price is determined when there is no trade. By taking Y1 to represent food and Y2 to represent television, the following graph illustrates how domestic price is determined. From the above graph, point A is the home autarky equilibrium. The indifference curve is employed in this case since it is assumed that both countries, that is, Italy and France have similar tastes and technology. Therefore, at point A, where the indifference curve is tangent to the production possibility frontier, is the autarky equilibrium. In order to determine an autarky relative price for home country or Italy, a price line or isovalue is drawn tangent to the PPF and the indifference curve as shown in the above graph. The isovalue or the price has a negative slope. Therefore, the relative domestic price for food will be, Pa= Pa1/ Pa2. The PPF for foreign country or France is drawn outside the PPF of the home country or Italy as shown in the above graph. In order to determine where the autarky equilibrium for the foreign country lies, Pa can be taken as also the autarky equilibrium in the foreign country. Therefore, by assuming Pa to be the autarky equilibrium in France or foreign nation, production needs to occur at the point where PPF of the foreign nation is tangent to the price line, which has a slope similar to that of the home country, that is, Pa. from the above graph, B’ is the point at which production will occur. According to Rybcynzski theorem, point B’ needs to lie above point A and to the left of point A. This is well illustrated in the above graph. The isovalue or the price line at point B’ acts as a budget constraint for consumers in the foreign country. In this price line, the consumer will choose will choose the highest indifference curve. With similar tastes in both countries, consumers in the foreign country will demand the same amount of food and television as consumers in the home country. Therefore, the foreign consumption should be on the budget constraint via point B’. It should also be on a ray from origin via point A. therefore, point C’, which is above and to the right of point A, is the point at which foreign consumption occurs. The home country, or Italy, has a lower relative price of food in autarky. This is due to the increased demand for food in the foreign country. It is believed that at price Pa, there will be high demand for food in the foreign country. The high demand will push up the relative price for food, such that the price at home country becomes less than the autarky price in the foreign country. 2.2) When France become more capital abundant, the quantities of television produced will increased as shown in the above graph. From the graph, the PPF of France will tilt outwards as an indication of increase in television production, brought about by France being more capital abundant. On the other hand, if Italy becomes less land abundant, Its PPF will shift inwards as shown in the graph below. Therefore, with Italy being less land abundant, the quantity of food produced will reduce, which can be illustrated by the inward tilt of its PPF. 2.3) In both countries, trade will cause the income of the owners of abundant factor to gain while those of scarce factor to lose. For example, in Italy, income of land owners will increase while the income of owners of capital will decrease. In France, the income of owners of capital will increase while the income of owners of land will decrease. This can be explained well by considering the relative price of the commodity. It is believed that with an increase in relative price of commodity, such as food, the factor that is employed intensively in its production will gain in real terms. However, the other factor such capital will lose. The owners therefore of the factor of production such as land will gain, while the owners of capital will lose in the home country. By considering the land rental rate to capital rental rate, it can be noted that L/K>L*/K*, at home country, where L represent Land while K represents capital. This therefore implies that with trade the home country has the ability to shift its production towards the commodity that employs land intensively and export it, thus utilizing its abundant factor effectively without reducing its wages. The owners of the abundant factor, that is, food will gain from trade, while the owners of the scarce factor, that is capital, will lose from trade. Bibliography Akran, G 2011, Ricardo’s Theory of Comparative Advantage - International Trade. < http://kalyan-city.blogspot.com/2011/02/ricardos-theory-of-comparative.html > Melitz, O.K 2012, International economics: Resources and Trade: The Heckscher-Ohlin Model. Pearson Addison-Wesley Ossa, R, Trade and Resources: The Heckscher-Ohlin Model. International commercial policy. Feenstra, R.C, Advanced International Trade: The Heckscher-Ohlin Model TORRE, A. International Trade. Deakin University Read More