International Trade & Investment

Assessment 1

Submitted to: Catia Montagna Submitted by:

Anna Zvarikova (090012475) Calum Fraser (110000740) Md. Nazmul Hasan (110000703)

Date of submission: March 04, 2011

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1.

Assume that the world economy consist of two countries, Switzerland and Turkey. The countries produce cotton and wine. Labour is the only factor of production. Per hour of labour, the countries produce the following quantities: Switzerland Turkey 2 4

Cotton (bales) Wine (litres)

3 9

If free trade were introduced, world trade would be composed as follows: (a) Switzerland will not trade as it is more efficient in both products; this makes all trade impossible. (b) Switzerland will export cotton, Turkey will export wine. (c) Switzerland will export wine, Turkey will export cotton. Choose the correct answer and explain your reasoning.

Answer: c) Switzerland will export wine, Turkey will export cotton. Labour productivity of wine in Switzerland is 3 times higher than cotton and is 2 times higher than cotton in Turkey. So Switzerland has comparative advantage in producing wine. In terms of opportunity cost: moving one hour of labour from cotton to wine in Switzerland yields 9 extra litres of wine and reduces cotton by only 3 bales. So the opportunity cost of producing wine in Switzerland is 3/9=.33 In Turkey, moving one hour of labour from cotton to wine yields 4 extra litres of wine and reduces cotton by 2 bales. So the opportunity cost of producing wine in Turkey is 2/4=.50, which is higher than Switzerland (.50>.33). So Switzerland has clear comparative advantage in producing wine. Similarly, the opportunity cost of producing cotton in Switzerland is 9/3=3, which is higher than Turkey 4/2=2. So, Turkey has comparative advantage in producing cotton (3>2). Since Switzerland has comparative advantage in producing wine, it should export wine and Turkey should export cotton following the assumption that countries should export goods in which they have comparative advantage. -2-

2.

Given question 1, suppose that Switzerland has 18 hours of labour, and Turkey has 30. Before free trade was introduced, both countries used half their labour force for each of the two products. What are the changes in world production of the two products? (a) Total production of cotton will increase by 3 bales and wine production will increase by 21 litres. (b) That depends on the quantities demanded. These quantities are not given, so the question cannot be answered. (c) Total production of cotton will increase by 9 bales and wine production by 3 litres. Choose the correct answer and explain your reasoning.

Answer: a) Total production of cotton will increase by 3 bales and wine production will increase by 21 litres. Before trade, Switzerland used 9 hours of labour to produce wine and 9 to produce cotton. Turkey used 15 hours of labour to produce wine and 15 to produce cotton (given both countries used half their labour force for each of the two products). So, the total production of both goods was: Before trade productionSwitzerland Cotton (bales) Wine (litres) 3*9=27 9*9=81 Turkey 15*2=30 15*4=60 Total 57 bales of cotton 141 litres of wine

After trade, Switzerland is using all its labour hours to produce wine and Turkey is using all its labour hours to produce cotton because of their specialisation. The new production of both the goods will be-

Switzerland Cotton (bales) Wine (litres) Total 0 18*9=162 162 litres of wine (141)

Turkey 30*2=60 0 60 bales of cotton (57)

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So free trade between Switzerland and Turkey increases the production of both goods. Specialisation has led to an increase in output of both goods (prespecialisation output is shown in brackets at the bottom of the table). 3. Given questions 1 and 2, suppose that free trade has been introduced. The wage per hour in Switzerland is 9, and the hourly wage in Turkey is 5. Will trade take place between the two countries? (a) No, the products produced in Turkey are too expensive for buyers in Switzerland. (b) Yes, Swiss consumers will buy the Turkish export product as it cheaper than the identical domestically produced good. Choose the correct answer and explain your reasoning.

Answer: b) Yes, Swiss consumers will buy the Turkish export product as it cheaper than the identical domestically produced good. Labour wage is lower in Turkey and therefore Turkey has cost advantage in producing cotton over Switzerland (given labour is the only factor of production). It does mean than Turkey can produce per bale of cotton at a lower cost than Switzerland. Per unit labour cost can be shown as follows: Per unit labour (production) cost (in Euros) Switzerland Cotton (bales) Wine (litres)
Wage in Switzerland/3= 9/3 = 3

Turkey
Wage in Turkey/2= 5/2 = 2.5

Wage in Switzerland /9= 9/9 = 1

Wage in Turkey /4= 5/4 = 1.25

Per unit labour cost of producing cotton in Switzerland is higher than Turkey and that is why Swiss consumers will prefer to buy imported cotton, holding all else constant.

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4.

What assumption has implicitly been made in question 3 above about the value of the exchange rate between Switzerland and Turkey?

Answer: Case 1: In this case the currency for measuring cost of production (labour wage) in both countries is the same. The assumption made in Q3 was that both countries have the same currency (Euros), so it will not have an effect on the trade between the countries with respect to the exchange rate variation. Case 2: But in real world, appreciation or depreciation of exchange rate does matter in trade between countries. Assuming: Switzerland wage in Franc is: Ws, Turkey wage in Lira is Wt Exchange rate: e is the number of Lira per Franc (i.e. 1Franc = e * 1Lira) Then the exchange rate between Switzerland and Turkey can be given by: e= Ws/Wt or e= 9/5 = 1.8 In terms of unit labour costs: (in Lira/unit) Switzerland Cotton Wine eWs/3 eWs/9 Turkey Wt/2 Wt/4

In present time, Because eWs/Wt > 3/2 then T has a cheaper labour cost in Cotton and eWs/Wt < 9/4 then S has a cheaper labour cost in Wine

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However, when e decreases that eWs/Wt < 3/2 then Turkey will lose its comparative advantage in producing Cotton. When e increases that eWs/eWt > 9/4 then Switzerland will lose a comparative advantage in producing Wine.

5.

Consider two economies, Japan and Australia, producing two goods, Food and Manufacturing (F&M), by using two factors of production capital (K) and land (L). a. Complete the following sentences: i. M is relatively capital-intensive and F is relatively land-intensive. K K Then, is >.than . L M L F ii. Japan is relatively abundant in capital and Australia is relatively abundant in land. Define land and capital endowments with L and K respectively. K K is >. than . Then, L Japan L Australia b. Let: pM be the price of M, pF be the price of F, V be the return to capital and [ be the return to land. Given the information contained in point a(i) and a(ii) above, complete the following sentences: i. [ [ is <than . V Japan V Australia

p p is >than F . ii. This in turn implies that F pM Japan pM Australia iii. This in turn implies that Japan has a comparative advantage in Manufacturing, while Australia has a comparative advantage in Food. c. In the graph below, (i) label the Production Possibilities Frontiers of the two countries, (ii) identify the relative prices of the two countries; (iii) identify the quantities that the two countries produce of each good.

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pF pM ?

pF pM ?

F
d. Now consider the case in which consumers in the two countries have the same preference structure (i.e. they have the same map of indifference curves). Assume that the two countries open up to free trade. In the same graph, draw the free trade price line and explain the trade pattern that would emerge by clearly identifying the two trade triangles. Answer:
New Price Line after Trade

M
(PF/PM )Japan M3 M2

Trade Triangle of Japan

Indifference Curve
Consumption (after trade) PTF/PTM

M0

Trade Triangle of Australia

M1 M4 (PF/PM) Australia

F3

F2

F0

F1 F4

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i)

Japans PPF is more skewed towards manufacturing, the K intensive good. Australias PPF is more skewed towards food, the L Intensive good. PPF for Australia and Japan is identified in the graph. The relative price of both the countries are identified in the graph as: pF pF pM Japan pM Australia

ii)

iii)

Australia will produce M1F1 (in the above graph) and Japan will produce M2F2.

d) In Australia, price of food (PF) increases relative to price of Manufacturing (PM) In Japan, price of Manufacturing (PM) increases relative to price of food (PF). The new trade price line is the red line in the graph. Trade pattern from the two trade triangles: y y When the countries are open to trade, consumers in Australia (Japan) will buy some manufacturing from Japan (Australia). Trade changes output mix. That allows Australian consumers to consume more manufacturing than before trade and the same goes to Japan (to consume more food). Australia produces more Food than it consumes and Japan produces more manufacturing than it consumes. Difference between what is consumed and produced is the trade. Australia will export food and Japan will export manufacturing (identified in the graph). What is the export for Australia is the import for Japan and what is the export for Japan is the import for Australia.

e. Would trade be beneficial for the country as a whole? Would the owners of all factors of production gain from trade? Briefly explain your answers.

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Answer: Free trade in goods, services and capital has improved the standards of living across the world. It has provided competition to drive innovation and productivity. International trade removes the basic constrains where a countrys consumption is not limited by their production. So trade would be beneficial for the country as a whole. Only the owners who can intensively use their factors of production can be benefited from trade.

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