Question

In Village A, one farmer, i.e., one unit of labor, can produce either 10 bottles of wine (W) or 2 bottles of olive oil (O). In Village B, one farmer can produce either 5 bottles of wine (W) or 15 bottles of olive oil (O). For now, the two villages are in a state of “autarky” and do not trade with each other or with anyone else. People in Village A consume 100 bottles of (W) and 20 bottles of (O), while people in Village B consume 50 bottles of (W) and no bottles of (O).

a)  How much labor is required per bottle of (W) and per bottle of (O) produced in each village? How many farmers does each village have? Explain your answer. [Mark: 0.5]

b)  Each village decides to specialize in the good in which it has comparative advantage. How much is the increase in the aggregate production of each good in the two villages relative to autarky? Explain your answer. Note: aggregate production means the sum of the production levels in the two villages. [Mark: 1.0]

c) The two villages decide to trade freely with each other. Assume that after free trade each bottle of (W) is worth 1.5 bottles of (O). At this price they trade 50 bottles of (W) between them. How many bottles of (W) and of (O) does each village consume? Explain your answer. [Mark: 1.0]

Answer 1

a) In village A, 1 unit of labor can produce 10 bottles of wine or 2 bottles of olive oil. Thus, one bottle of wine is produced by 0.1 units of labor and one bottle of olive oil is produced by 0.5 units of labor.

Now, as the village A is producing 100 bottles of W and 20 bottles of O, there are 20 units of labor in village A.

In village B, 1 unit of labor can produce 5 bottles of wine or 15 bottles of olive oil. Thus, one bottle of wine is produced by 0.2 units of labor and one bottle of olive oil is produced by 0.067 units of labor.

Now, as the village B is producing 50 bottles of W and 0 bottles of O, there are 10 units of labor in village B.

b) Here, village A has comparative advantage in the production of wine whereas, village B has comparative advantage in the production of olive oil.

With 20 units of labor, village A will produce 200 bottles of wine.

Similarly, with 10 units of labor, village B will produce 150 bottles of olive oil.

Aggregate production is 200 bottles of wine and 150 bottles of olive oil.

Whereas, under autarky, aggregate production was 150 bottles of wine and 20 bottles of olive oil.

c) If free trade takes place at a rate of: 1 bottle of wine can be exchanged for 1.5 bottles of olive oil ,

then, Village A can export 50 bottles of wine to village B and consume remaining 150 bottles of wine. In return, village A gets 75 bottles of wine. Thus, village A consumes 150 bottles of W and 75 bottles O.

Similarly, Village B can have 50 bottles of wine by exporting 75 units of olive oil. Thus, village B will have 150-75 = 75 bottles of olive oil for consumption. Thus, village B consumes 50 bottles of W and 75 bottles O.