Question 1:
In the table below labour is the only input used to produce corn and melons.
Country Corn Melons Labour Endowment
United States 5 tonnes 2 tonnes 1000 workers
Mexico 1 tonnes 1 tonnes 1000 workers
(a) Who has the absolute advantage in producing corn? in melons?
The U.S. has the absolute advantage in both
(2 marks)
(b) Who has a comparative advantage in corn? in melons? Explain any differences from
your previous answer.
The US in corn and Mexico in melons
(2 marks)
(c) What are the limits on relative price after trade opens between the two countries, i.e
for trade to be beneficial to both countries at what rate would Mexico be willing to
swap one product for another? What about the US?
Prices reflect opportunity costs in both the US and Mexico. The price ratio after trade
must therefore lie between 2/5 and 1.
(2 marks)
(d) Suppose after trade the actual relative price is 2 melons for 3 bushel of corn. Draw
Production Possibility Frontiers and Trading Possibility Frontiers for the two
countries.
After trade, the United States will specialize in corn and Mexico in melons. At the assumed
relative price of 2/3, each US bushel of corn buys 2/3 of a melon. The whole 5000 bushels of
US corn would therefore buy 10,000/3 = 3,333.33 melons — beyond American production
possibilities of 2000 melons. (2 marks)
Each Mexican melon would buy 3/2 of a bushel of corn. The whole 1000 Mexican melons
would therefore buy 1,500 bushels of corn — beyond Mexican production possibilities. (2
marks)
1
Question 2
Suppose the price elasticity of demand for cigarettes is -0.25 and that Australians purchase
about 22 billion cigarettes each year.
(a) If the tax on cigarettes were increased enough to raise the price of cigarettes by 50
percent, what would be the new quantity of cigarettes purchased?
(b) Is raising the tax on cigarettes a more effective way to reduce smoking if the demand
for cigarettes is elastic or if it is inelastic? Briefly explain.
(a) (Percentage change in price) x (price elasticity of demand) = percentage change in quantity: 50%
x –0.25 = –12.5%. (2 marks) So, the quantity of cigare&es demanded should decline 12.5% from its
current level of 22 billion per year. 12.5% of 22 billion is 2.75 billion ( 2 marks) and the new quantity
purchased would be 19.25 billion. (2 marks)
(b) If the demand for cigare&es was price elastic, the price increase resulting from a tax increase will
