Typos corrected: fun and games in Q3 were interchanged by mistake in several places that are noted now for your reference. (10 marks) Think of the simple gravity model. Suppose there are two countries: the US and Mexico. Mexico’s GDP is 25 while the US’s GDP is 50. The distance between the US and Mexico is 2 while A equals 6. (2 marks) Using the information in the question setup, what is the predicted amount of trade that should occur between the US and Mexico? (3 marks) If the GDP of Mexico doubles, and the GDP of the US triples at the same time, what would the new predicted level of trade be according to the simple gravity model? Compare this to your answer in a). (5 marks) Take your original answer in a), which tells you how much predicted trade should occur based on the gravity model. Now suppose the actual amount of trade that occurs between US and Mexico is 8000. Can you give at least one reason why this is different from what the gravity model predicts, if it is different from your answer in a)?
If it is the same as your answer in a), explain why. (45 marks) Consider two countries: Canada (CAN) and Iceland (ICE). Two goods can be produced: gloves (g) and socks (s). Goods are produced only using labour, and the unit labour requirements of the two goods in each country are given in the following table: 2 8 3 6 Assume that Canada has 3000 units of labour, while Iceland has 1500 units of labour. When setting up any diagrams, express everything in terms of gloves, relative to socks. For example, the RS-RD curves should be expressed in relative quantities and prices of gloves (relative to socks). (3 marks) Who has a comparative advantage in each good? Why? Show your calculations, if any are needed. (5 marks) Assume that, under free trade, the RD curve intersects the RS curve where the relative price of gloves equals 1/3. Draw a fully labelled RS-RD curve diagram, which clearly labels each curve and also the height of each “step” in the RS curve on the y-axis, as well as the relative quantity at which the vertical portion of the RS curve lies. (5 marks) Calculate what the relative wages (Canada’s wages divided by Iceland’s wages) would be, after opening up to trade as in part b). (Note: you have all the information needed to do this part; you do not need the specific prices of each good!). (5 marks) Draw a PPF and an expanded consumption possibilities curve, as in lecture, to show how Canada gains from opening up to trade in part 2b). Please draw a diagram, but also briefly explain in words how Canada gains from trade.
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