Suppose two countries, India and China, produce two goods: transport equipment and pharmaceutical products. Suppose, India and China have identical technologies to produce transport equipment and pharmaceutical products. Assume that land is specific to transport equipment, capital is specific to pharmaceutical products, and labor is free to move between the two industries. When India and China engage in free trade, the relative price of pharmaceuticals falls in India and the relative price of transport equipment falls in China.

i. In a graph, show how the wage changes in India due to a fall in the price of pharmaceuticals, holding constant the price of transport equipment. Can we predict that change in the real wage?

ii. What is the impact of opening trade on the rentals on capital and land in India? Can we predict the change in the real rental rates (returns) on capital and land?

iii. What is the impact of opening trade on the rentals on capital and land in India? Can we predict that change in the real rentals on capital and land?

iv. In each country, has the specific factor in the export industry gained or lost and has the specific factor in the import industry gained or lost? Now assume, China exports transport equipment to India and imports pharmaceutical products from India, though it can produce both these goods at costs lower than India.

v. If costs are invariant with respect to output levels and markets in both countries are perfectly competitive, how will you explain this pattern of trade? Assume further that United States, on the other hand, has better technology for producing transport equipment but inferior technology in producing pharmaceutical products. Per capita income is the highest in us and the least in India.

vi. Will there be any bilateral trade between China and India under this scenario?

vii. Will there be any bilateral trade between China and US? If so, what will be the pattern of trade?

2. Consider two countries Home and Foreign producing two goods, cars and planes. Suppose that each worker in Home can produce 2 cars (c) or 3 planes (p). Assume also that Home has 4 workers. Suppose that each worker in Foreign can produce 3 cars or 2 planes. Foreign also has 4 workers.

i. Graph the production possibilities frontier for Home. What is the no-trade relative price of cars in Home?

ii. Graph the production possibilities frontier for Foreign. What is the no-trade relative price of cars in Foreign?

iii. In which good does Foreign have a comparative advantage, and why?

iv. Suppose that in the absence of trade, Home consumes 2 cars and 9 planes, while Foreign consumes 9 cars and 2 planes. Add the indifference curve for each country to the figures you have drawn for i. and ii. above. Label the production possibilities frontier (PPF), indifference curve(U1), and the no- trade equilibrium consumption and production for each country.

v. Now suppose the world relative price of cars is Pc/Pp = 1. In what good will each country specialize? Briefly explain why.

vi. Graph the new world price line for each country in the figures above and add a new indifference curve (U2) for each country in the trade equilibrium.

vii. Label the exports and imports for each country. How does the amount of Home exports compare with Foreign imports? Does each country gain from trade? Briefly explain why or why not.

viii. When trade is opened, what happens to the relative price of corn in Foreign and to the relative price of corn in Home?