Alejandra Nozal and Helena Montero

Group 58
INTERNATIONAL ECONOMICS: INTEGRATION
PROBLEM SET 2

Consider two countries, Mytown and Yourtown. Two goods are produced: mobile phones and champagne.
In Mytown the unit labour requirements for mobile phones and champagne are 10 units and 10 units
respectively. In Yourtown the unit labor requirements for mobile phones and champagne are 40 and 10
units respectively. Mytown has a labor force of 100 units while Yourtown has a labor force equal to 200
units.

1. Describe the absolute and relative (comparative) advantages from each country.

Absolute advantage: we compare cost industry by industry.

Mobile phones: M has an absolute advantage in the production of mobiles phones, as it requires 4 times less
units of labor requirement than Y.

Champagne: there is no absolute advantage in the production of champagne as both countries require the
same labor to produce one unit.

Relative advantage: technically, we need to compare the relative productivity of one country in one sector,
with the productivity of that country in the other sector.

M has a comparative advantage in the production of phones and Yourtown has a comparative advantage in
the production of champagne:

Unit labor requirements (a) MOBILE PHONES (MP) CHAMPAGNE (C)

MYTOWN (M) 10 10

YOURTOWN (Y) 40 10

aMmp < aYmp (10<40) → M has an ab adv

Labor force (A) → MYTOWN (M): 100 units | YOURTOWN (Y): 200 units

Labor force (A) MOBILE PHONES (MP) CHAMPAGNE (C)

MYTOWN (M) 10/100= 0,1 10/100= 0,1

YOURTOWN (Y) 40/100= 0,4 10/100= 0,1

2. Find the equation that represents the production possibility frontier (PPF) of Mytown and YourTown and
draw a graph of each.
 Alejandra Nozal and Helena Montero
Group 58

3. Find the autarchy equilibrium prices and explain why is this the case.

MYTOWN AUTARCHY EQUILIBRIUM PRICE

Pm/Pc= 1

- At Pm/Pc=1, MYTOWN is indifferent to produce champagne or phones as the relative price is

equal to the relative cost.
- If Pm/Pc >1, MYTOWN will produce only phones, as the relative price is higher than the
relative cost.
- If Pm/Pc<1, MYTOWN will produce only champagne, as the relative price is lower than the
relative cost.

YOURTOWN AUTARCHY EQUILIBRIUM PRICE

Pm/Pc= 4

- At Pm/Pc=4, YOURTOWN is indifferent to produce champagne of phones as the relative price is equal
to the relative cost.
- If Pm/Pc> 4, YOURTOWN is going to produce only phones, as the relative price is higher than the
relative cost.
- if Pm/Pc< 4, YOURTOWN will produce only champagne, as the relative price is lower than the relative
cost.

4. Consider the relative price P m/P c = 2. If firms maximize profit, at these relative prices find the
production levels from each country (also show this result in the PPF graphs you draw for each country).

Given Pm/Pc= 2, then M will produce mobiles whilst Y will produce champagne. Mytown produces 10 mobile
phones and Yourtown produces 20 units of champagne. The gains from trade are the following: Mytown now
obtains 20 bottles of champagne (instead of 10) for the production of 10 phones and Yourtown obtains 10
mobiles phones for the production of 20 bottles of champagne instead of 5.
 Alejandra Nozal and Helena Montero
Group 58

5. Find the GDP of both countries if P m/P c = 2 (you can use your answer to the previous question).
Hint: GDP is the value of production of a country, that is: GDP = P mQm + PcQc. Since we only have
information about relative prices (i.e. Pm/Pc) and we know nothing about absolute prices, the value of
GDP is not a number and it will be in terms of one of the prices. Another choice is to find the GDP in
terms of Mobile Phones or Champagne.

Mytown → GDP = Pm * 10 + Pc * 0 = 10Pm = 10 * 2Pc = 20Pc

Yourtown → GDP = Pm*0 + Pc*20 = 20P

6. It is time for consumers to maximize their utility and derive the demand function. In order to make
the exercise more simple, assume that each country has one representative consumer that receives all
the GDP as incomer (i.e. GDP = Y). Find the demand for mobile and champagne for each country when
Pm/Pc = 2. Before answering the question, you need a demand function. In the reduced class we will
prove that if the utility function is U (CM , CC ) = C 1/2 C 1/2 , where CM represents the quantity consumed
of mobile phones, and CC MC the consumption of champagne, then the demand for champagne is D c =
Y/(2Pc) and the demand of mobile is represented by D m = Y/(2Pm). Therefore all you have to do is to
substitute the GDP data and the relative price information into the demand function and you will find
the demand for each good in each country.

MYTOWN:

Dm= Y/(2pm) = 10*Pm/(2*Pm) = 5

 Alejandra Nozal and Helena Montero
Group 58
Dc= Y/ (2Pc) = 10*Pm/2* Pc= 10*2Pc / 2Pc = 10

YOURTOWN:

Dm= Y/(2pm)= 20*Pc/(2*Pm) = 20*O.5Pm / 2*Pm = 5

Dm= Y/(2pm)= 20*Pc/(2*Pc) = 20*Pc / 2*Pc = 10

7. Is P m/P c = 2 a world equilibrium relative prices? (prove that exports are equal to imports)

Firstly:

X= production- demand M= demand + production

MYTOWN (world trade):

XmM= 10-5= 5

McM= 0 +10= 10

YOURTOWN (world trade):

XxY= 20- 10= 10

MmY= 0 +5= 5

8. Has welfare increase? Prove for Mytown that welfare has increased (i.e. compare the consumption
before trade and after trade). MAKE A GRAPH OF THIS RESULT (if you want to prove it also for
Yourtown, you are welcome to do it). You also have an alternative method: you can substitute the
consumption quantities into the utility function and see if the utility has increased after trade. To
calculate the consumption levels under autarchy can be a little bit tricky since at autarchy prices, firms
are willing to produce at any point along the PPF, then which point you should choose in order to
calculate the GDP (=Y)? Very easy, since at autarchy prices any point along the PPF gives the same level
of GDP, you can choose an arbitrary point.

Gains from trade: the green area shows the gains from trade, which increases the possibility of
consumption in both economies. These gains are explained by the export and import prices.
 Alejandra Nozal and Helena Montero
Group 58

9. Now assume that Yourtown has 400 workers instead than 200. What your intuition tells you about
the change in welfare at Yourtown if they open to trade? With how many workers is the welfare higher?
With 400 or 200?

If the relative price remains the same, then the GDP will be double and GDP per capita will not change.
Nevertheless, equilibrium relative price may be lower because of an increase in the production of champagne.