Homework 2-

1. Absolute and Comparative Advantage

The U.S. and China produce two goods - t-shirts and sweaters. The U.S. has 100 workers and China has 200 workers. Assume that labor is the only factor of production used in making these goods. With 100 workers the U.S. can either produce 1,000 t-shirts or 300 sweaters. With 200 workers China can produce 1000 t-shirt or 500 sweaters.

i) Assume the production possibility frontier (PPF) is linear. Draw the PPF for each country

ii) Which country has the absolute advantage in the production of sweaters? Which country has the absolute advantage in the production of t-shirts?

iii) Would the two countries trade? If so, what is the range of price (in terms of t-shirts) for which a sweater would trade. If the price of a t-shirt is 20 dollars, what can we say about the price of a sweater?

2. Let the domestic demand for sweaters in a small open economy be given by P=90-2Q. Let the domestic supply for sweaters in a small open economy be given by 4P = Q. The world price for sweaters is $15 per sweater. 

i) If the country is open to trade how many sweaters will domestic producers produce?

ii) Assume that sweaters are the only good traded by the country. Will the consumers be for or against free trade? Explain why consumers hold their position.

iii) Suppose the government imposes a tariff of 2 dollars on sweaters. What is the tariff revenue?

iv) Assume that the world price of a sweater is 5 dollars. Will the consumer be for or against free trade given this world price? Will the producers be for or against trade at this world price? Explain your answer.

v) Suppose the world price of sweaters is $5 and this government imposes a tariff of 3 dollars on sweaters. What is the tariff revenue?

vi) Calculate the deadweight loss from the imposition of the tariff described in part (v) of this problem.

vii) Assume the world price of sweaters is still $5 per sweater. But now the government decides to use a quota instead of a tariff to restrict trade. In addition, the government wants to ensure that the quota rent from imposing the quota is the same as the tariff revenue generated from the previous policy. What should the amount of the quota be in order for the quota rent to equal the tariff revenue? What is the deadweight loss with this policy?

3. Let the demand for sweaters in a small open economy be given by Q = 200 - 2P. Let the supply for sweaters in a small open economy be given by Q = 3P - 100. Suppose that there is a sweater quota in place in this economy and no other trade restrictions. Suppose domestic suppliers are producing 50 sweaters when the quota is in place.

i) What is the amount of the quota?

ii) Suppose that the quota rent is 250 dollars. What is the world price of sweaters?