Question

A neighboring city looks identical in every way (except each house in the neighboring city requires only half the electricity and only ¼ of the water is produced for use compared with the city in the above questions – which sacrifices 1 unit of water for 1 unit of electricity). Use comparative advantage to determine which city will supply water and which will supply electricity. Estimate the price range of electricity in terms of water.

Answer 1

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Given the above information the table can be made-

Electricity Water

Neighboring city 1/2units 1/4units

City 1 unit 1 unit

Opportunity costs of producing each unit =>

Electricity Water

Neighboring city (1/2)/(1/4) = 2units (1/4)/(1/2) = 1/2units

2E = 1W 1E = 1/2W

City 1/1 = 1 unit 1/1 = 1 unit

1E = 1W 1E = 1W

We can see from the above table that the Neighboring city can produce 2 units of electricity by sacrificing 1 unit of water and another city can produce only 1 unit of electricity by sacrificing 1 unit of water. It means the neighboring city has a lower opportunity cost than the another city. Therefore the neighboring city has a comparative advantage in the production of electricity.

So, Neighboring will supply electricity and another city will supply water.

Trade will happen between the two cities only if the neighboring city can get more than 1/2 units of water by giving up 1 unit of electricity and another city can get 1 unit of electricity by giving less than 1 unit of water.

Hence, the price range of electricity in terms of water will be 1/2W < W < 1W.