Question 2 (25 marks = 6 + 2 + 12 + 5) Assume that the standard assumptions of the Ricardian model hold. Suppose that the following Table shows the output in terms of units of coal (C) and pairs of shoes (S) that is produced when 1 unit of labour is employed in the UK and in Italy: UK Italy Coal 3 1 Shoes 6 3

a) What is the opportunity cost of producing a pair of shoes in terms of coal in the UK? What is the opportunity cost of producing a pair of shoes in terms of coal in Italy?

b) What is the price ratio (of shoes to coal) in UK under autarky, that is Ps/Pc? What is the price ratio in Italy under autarky, that is Ps*/Pc*?

c) Suppose that after allowing free trade the world equilibrium price ratio, (Ps/Pc)W, lies somewhere between Ps/Pc and Ps*/Pc*, but is not equal to either Ps/Pc or 2 Ps*/Pc*. Also, suppose the amount of labour in the UK is L and in Italy is L*. Sketch the following with coal on the vertical axis and shoes on the horizontal axis.

i) On the same diagram, sketch for UK the transformation curve (also called production possibilities frontier), and the budget line (also called isovalue lines) after trade is allowed. Please label the lines, axes and slopes and intercepts of the lines.

ii) On a separate diagram, sketch for Italy the transformation curve, and the budget line after trade is allowed. Please label the lines, axes and slopes and intercepts of the lines.

iii) Use the above diagrams to answer the following. Which country specializes in which product? Do both countries gain from trade? Illustrate the gains from trade (if any) on the diagrams you drew for (i) and (ii).

d) Suppose that after allowing free trade the world equilibrium price ratio, (Ps/Pc)W, equals the autarky price ratio in Italy, Ps*/Pc*. Which country produces which product(s)? Do both countries gain from trade? Illustrate your answer using the relevant diagrams.