Chap006EndofChapterproblems

Chap006EndofChapterproblems - Chapter 06 - Gains from Trade...

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CHAPTER 6 GAINS FROM TRADE IN NEOCLASSICAL THEORY V. Answers to End-of-Chapter Questions and Problems 1. Figures 1 and 2 in the text are the relevant diagrams. Point E is the production equilibrium position because the marginal rate of transformation in production (= marginal cost of X/marginal cost of Y) is equal to the relative commodity price ratio P X /P Y at that point. For the given relative prices, production at any other point would have P X /P Y unequal to MC X /MC Y , or P X /MC X unequal to P Y /MC Y . Hence, firms would have an incentive to shift resources until point E was attained. For consumers, point E in Figure 2 is the equilibrium position because, at that point, the marginal rate of substitution in consumption (= marginal utility of X/marginal utility of Y) is equal to P X /P Y . Consumption on the PPF at any other point would be on a lower indifference curve, and, for the given prices, MU X /MU Y would be unequal to P X /P Y (or MU X /P X would be unequal to MU Y /P Y ). Because consumption of one good at the margin brings less utility per dollar spent than on the other good, consumers will change their consumption bundle until point E is attained. In order for the country to gain from trade, the world P X /P Y must be different from the autarky P X /P Y . With different relative prices on the world market, a reallocation of production and consumption will enable the country to move to a higher indifference curve. 2. Yes, the country should trade. It should export cloth because that is the good of comparative advantage, and producers will have a profit incentive to sell cloth at its relatively higher price on the world market. The country will gain from trade because its trading line (CPF with trade) will permit larger consumption bundles than are possible in autarky, since the exported cloth allows for the purchase of relatively cheaper machines than in autarky. As long
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Chap006EndofChapterproblems - Chapter 06 - Gains from Trade...

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