Chapter 2 The Gains from Trade 3

The common endowment is given by E. Countries differ in their preferences as represented by

the different indifference curves, y and y'. The autarky price ratios are given by AEB for the

home country and A'E'B' for the foreign. At an intermediate price ratio such as CED, home can

gain by exporting clothing and importing food (to reach a point such as F), whereas the foreign

country does the opposite (to obtain consumption at a point such as F').

5.

(a) The production possibilities schedule for this economy is the downward sloping straight line of

20 and horizontal intercept of 40. The indifference curves are right-angled with the corners lying

along the dotted line through the origin. In autarky, consumers will then consume at point E. This can be found by finding the intersection of the PPF, represented by Q f= 20 - (1/2)Q c and the ray along which the corners of the indifference curves lie, represented by Q f= 2Q c This should yield Q f= 16 and Q c= 8.

(b) In autarky, the relative price of food will be given by the inverse of the slope of the PPF, which

will be equal to 2.

(c) If the price of clothing doubles with trade, the relative price of food falls to 1. This will cause the

economy to shift all production into clothing, and they will then trade along the dotted line that

intersects both the horizontal and vertical axis at a value of 40 (which represents a relative price

of food equal to 1). They will trade along this line until they reach the line where Q f=2Q c This

point, E', corresponds to Q f= 80/3 and Q c= 40/3.

(d) The country is obviously better off with trade in that they are consuming more of both goods.

However, they are not consuming twice as much of both goods.