Economics -International Trade

Practical Application 2.2

There are two countries, Western and Eastern. They produce two goods, Coffee and Tea, using labor as a single resource. Suppose that Eastern grows. Economic growth: increase in output.

What can cause economic growth?

Increase in the population (better: increase in the labor force).

Growth of capital (outside the current model but important!).

Better technology, namely growth in productivity, which in the context of our model means a decrease in the unit labor inputs.

Western can produce a maximum of 500 units of Tea and 400 units of Coffee. Eastern can produce a maximum of 1000 units of Tea and 200 units of Coffee.

Placing the quantity of Tea on the horizontal axis, draw the Production Possibility Frontiers of the two countries. Then draw the Relative Supply of Tea (total quantity supplied of Tea, divided by the total quantity supplied of Coffee).

On this graph, draw a relative demand curve such that the resulting World Relative Price of Tea versus Coffee when the two countries trade is intermediate between the two relative autarky prices. Using this World Price, draw price lines on both Production Possibility Frontiers and two indifference curves, where consumers are optimizing.

Now suppose that Eastern grows: its unit labor inputs become half of what they were before. On the graphs, you just drew, redraw any changes to the Production Possibility Frontiers, to the Relative Supply or Relative

Demand curves, to the price lines, or to indifference curves. Label everything before the growth with subscript "1", and everything after the growth with subscript "2". Label Western and Eastern with subscript W and E, respectively. For example, "ICW1" is the Western's indifference curve before the growth, "ICE2" is the Eastern's indifference curve after the growth (if it's different). Assume throughout that each country fully specializes.

For full credit, you must label all axes, all figures, and all each individual curve. Your graph must contain all numbers to correctly position the figures. For grading purposes, it's vital you draw a very large, very neat figure.

Use your graphs to answer the following questions.

Which country has Comparative Advantage in Tea and Coffee? Does Comparative

Advantage change after the economic growth? Discuss how economic growth could be different, in such a way that the Comparative Advantage switches countries.

What is a reasonable relative price of Tea (the price of Tea divided by the price of Coffee) before the economic growth? How about after the economic growth?

Discuss which country (or countries) gain, and which lose, due to this economic growth