Assume that Home and Foreign produce only two goods –

Assume that Home and Foreign produce only two goods – wheat and carrots. Home has 1000 units of labour available. In Home, the unit labour requirement in wheat production is 4 and in carrot production it is 2. On the other hand, Foreign has 750 units of labour available. Foreign’s unit labour requirement in wheat production is 5, while in carrot production it is 1.

a. Graph both Home’s and Foreign’s production possibility frontiers.

b. Calculate the opportunity cost of producing wheat in terms of carrots in both Home and Foreign.

c. In the absence of trade, what would the price of wheat in terms of carrots be in both countries? Why?

d. Construct the world relative supply curve. You are required to explain and show on your diagram the relative prices at which the relative supply curve is horizontal and the relative quantity at which the relative supply curve if vertical. Now suppose world relative demand takes the following form: Demand for wheat/demand for carrots = price of carrots/price of wheat.

e. Graph the world relative demand curve along with the world relative supply curve. You are required to show at least three points that you used to derive the relative demand curve.

f. What is the free-trade equilibrium relative price of Wheat?

g. Describe the pattern of specialization and trade.

h. Show that both Home and Foreign gain from trade.

i. Suppose that the number of workers decreases from 1000 to 600 in Home. Find the new equilibrium relative price and show it on the diagram.

j. Suppose that Home has now 600 workers, but they are twice as productive in both industries as we have been assuming. Consider Foreign to have the initial 750 workers only and the same productivity in both industries. Construct the world relative supply curve and determine the equilibrium relative price. How do the gains from trade compare with those in the case described in problem h.