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

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.