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EC271PS1Ans - EC 271 Answers to Problem Set#1 International...

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EC 271 International Economic Relations Answers to Problem Set #1 Prof. Murphy Chapter 3 – Krugman and Obstfeld 1. (a) The production possibility curve is a straight line that intercepts the apple axis at 400 (1200/3) and the banana axis at 600 (1200/2). (b) The opportunity cost of apples in terms of bananas is 3/2. It takes three units of labor to harvest an apple but only two units of labor to harvest a banana. If one foregoes harvesting an apple, this frees up three units of labor. These 3 units of labor could then be used to harvest 1.5 bananas. (c) Labor mobility ensures a common wage in each sector and competition ensures the price of goods equals their cost of production. Thus, the relative price equals the relative costs, which equals the wage times the unit labor requirement for apples divided by the wage times the unit labor requirement for bananas. Since wages are equal across sectors, the price ratio equals the ratio of the unit labor requirement, which is 3 apples per 2 bananas. 2. (a) The production possibility curve is linear, with the intercept on the apple axis equal to 160 (800/5) and the intercept on the banana axis equal to 800 (800/1). (b) The world relative supply curve is constructed by determining the supply of apples relative to the supply of bananas at each relative price. The lowest relative price at which apples are harvested is 3 apples per 2 bananas. The relative supply curve is flat at this price. The maximum number of apples supplied at the price of 3/2 is 400 supplied by Home while, at this price, Foreign harvests 800 bananas and no apples, giving a maximum relative supply at this price of 1/2. This relative supply holds for any price between 3/2 and 5. At the price of 5, both countries would harvest apples. The relative supply curve is again flat at 5. Thus, the relative supply curve is step shaped, flat at the price 3/2 from the relative supply of 0 to 1/2, vertical at the relative quantity 1/2 rising from 3/2 to 5, and then flat again from 1/2 to infinity. 3. (a) The relative demand curve includes the points (1/5, 5), (1/2, 2), (1, 1), (2, 1/2). (b) The equilibrium relative price of apples is found at the intersection of the relative demand and relative supply curves. This is the point (1/2, 2), where the relative demand curve intersects the vertical section of the relative supply curve. Thus the equilibrium relative price is 2. (c) Home produces only apples, Foreign produces only bananas, and each country trades some of its product for the product of the other country. (d) In the absence of trade, Home could gain three bananas by foregoing two apples, and Foreign could gain by one apple foregoing five bananas. Trade allows each country to trade two bananas for one apple. Home could then gain four bananas by foregoing two apples while Foreign could gain one apple by foregoing only two bananas. Each country is better off with trade.

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