1. INTERNATIONAL ECONOMICS Lecture 6 | Lucía Rodríguez | Why do countries trade? Some later answers

2. TESTING NEOCLASSICAL THEORY Suppose the MRS of wheat for cloth in a country equals 1.5 and the international exchange ratio is 1.0. Explain how this country will adjust its consumption of wheat and cloth if it can trade at international prices.

3. MRS = MUx/ MUy= 1.5 Px/ Py = 1.0 TESTING NEOCLASSICAL THEORY Good Y Good X MRS x,y = ΔY/ ΔX = MU x /MU y D E MUx/ MUy > Px/ Py

4. TESTING NEOCLASSICAL THEORY In isolation Country A produces 8 million tons of rice and 14 million tons of beans. One ton of rice exchanges for 2 tons of beans, and there are constant costs. – Construct Country A’s PPC, and label its endpoints. – Suppose Country A now has the opportunity to trade with Country C at the exchange ratio 1R:1B. In equilibrium Country A consumes 16 million tons of beans. What will Country A produce after trade? What will Country A consume after trade? Show its consumption point and its trade triangle. What is the gain from trade (in real terms) in Country A?

5. TESTING NEOCLASSICAL THEORY Country A’s PPC: MRT = 1/2; International Prices = 1/1; – A will fully specialize in producing beans. Initial consumption point: (7,16); by trading consumers reach (14,16): » A exports (30 – 16) tons of beans: » It obtains 14 tons of rice in exchange (imports). Beans Rice 15 30 A 8 14 30 16 7

6. TESTING NEOCLASSICAL THEORY How do increasing-cost conditions affect the extent of international specialization and exchange? Why is a country less likely to become completely specialized in this situation compared to one of constant costs?

7. TESTING NEOCLASSICAL THEORY Suppose Honduras can produce 120 million tons of bananas if it uses all of its productive resources in the banana industry, or 90 million square meters of cloth if it uses all of its resources in the cloth industry. Use a diagram to illustrate your answers to the following questions. Label the diagram and explain in words. – Assuming constant opportunity costs, draw the Honduran PPC. – With no trade, suppose Honduran consumers choose to consume 40 million tons of bananas. How much cloth will Honduras then be able to produce? – What is the autarky price or the barter exchange ratio in Honduras?

8. TESTING NEOCLASSICAL THEORY – Now suppose Honduras has the chance to engage in international trade and that the world exchange ratio is 1B: 1C. What will happen with the allocation of resources in Honduras? Explain why. – If Honduras consumes 50 million tons of bananas after trade begins, how much cloth will it consume? – What is the gain from trade to Honduras?

9. TESTING NEOCLASSICAL THEORY Honduras’ PPC; MRT  120 bananas – 90 cloth. – MRT = 0.75 – First consumption bundle: (40, 60) – Autarky price: 1 Bananas – 0.75 cloth; 1 cloth – 1.33 bananas Cloth Bananas 90 40 60 120

10. TESTING NEOCLASSICAL THEORY Honduras engages in international trade, with international prices 1B : 1C. – Honduras fully specializes in bananas. – New consumption bundle (50, 70) Cloth Bananas 90 40 60 120 70 50