Microsoft Word - ps 1.docx

Consider the following model of trade between Iceland and Finland. There are two goods: Fish and Wheat. The only factor of production is labor. Each Icelandic worker can produce 1 unit of fish or 1 unit of wheat per unit of time, while each Finnish worker can produce 2 units of fish or 4 units of wheat per unit of time. There are 3 million workers in Iceland and 1 million in Finland. The relative demand in each country is given by

RD: . Note that since both countries have the same relative demand, this is also

the world's relative demand.

a. Which country has an absolute advantage in fish? In wheat? Which country has a comparative advantage in fish? In wheat?

b. Find the relative price of fish in both countries when there is no trade (each country is isolated). Express the relative price as the price of fish divided by the price of wheat. Draw the typical worker's budget line in both countries.

c. Graph the relative demand in a diagram with the relative price of fish (PF/PM) on the vertical axis and the relative quantity of fish (QF/QM) on the horizontal axis.

d. Derive the world relative supply curve and draw it on the same figure as you created for part c.

e. Compute the equilibrium relative price of fish under free trade, and draw the budget lines for a typical worker in each country. Which country produces which good(s)? Is there complete specialization? Who gains from trade?

f. What happens (conceptually) if the population of Iceland falls?