Consider a Ricardian model where both countries have expenditure share on manufactures 𝜃=12, Country 1 has 𝐴𝑚=2 and 𝐴𝑠=4, Country 2 has 𝐴𝑚∗=2 and 𝐴𝑠∗=3 and 𝐿=𝐿∗=100. Which of the following is TRUE? With free trade:Group of answer choicesCountry 1 consumes 𝐶𝑚=200 and 𝐶𝑠=200Country 2 consumes 𝐶𝑚∗=100 and 𝐶𝑠∗=200The relative price of manufactures to services is 𝑃𝑚𝑃𝑠=3
Question
Consider a Ricardian model where both countries have expenditure share on manufactures 𝜃=12, Country 1 has 𝐴𝑚=2 and 𝐴𝑠=4, Country 2 has 𝐴𝑚∗=2 and 𝐴𝑠∗=3 and 𝐿=𝐿∗=100. Which of the following is TRUE? With free trade:Group of answer choicesCountry 1 consumes 𝐶𝑚=200 and 𝐶𝑠=200Country 2 consumes 𝐶𝑚∗=100 and 𝐶𝑠∗=200The relative price of manufactures to services is 𝑃𝑚𝑃𝑠=3
Solution
In the Ricardian model, countries will specialize in the production of the good in which they have a comparative advantage. Comparative advantage is determined by the relative productivity of the two goods within each country.
First, let's determine which country has a comparative advantage in which good.
Country 1's productivity in manufactures is 2 and in services is 4, so the opportunity cost of manufactures in terms of services is 2/4 = 0.5 in Country 1.
Country 2's productivity in manufactures is 2 and in services is 3, so the opportunity cost of manufactures in terms of services is 2/3 = 0.67 in Country 2.
Since 0.5 < 0.67, Country 1 has a comparative advantage in manufactures and Country 2 has a comparative advantage in services.
With free trade, each country will specialize in the production of the good in which it has a comparative advantage. Therefore, Country 1 will produce and export manufactures, and Country 2 will produce and export services.
The relative price of manufactures to services cannot be determined from the information given. It will depend on the terms of trade, which is determined by supply and demand in the international market.
Therefore, none of the given options are necessarily true.
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