Question

Construct an original numerical example of a Ricardian model in which one country has an absolute advantage in the production of both goods.

1. Make an assumption about the amount of labor resource available in each country, then draw each country’s PPF.
2. Will trade be mutually advantageous in your example? If not, why not? If trade is mutually advantageous, give an example of one international terms of trade that would make trade mutually advantageous.

Answer 1

Suppose countries A and B have equal amount of labor resources available and each country can produce two goods (cloth and wine). With all available resources, country A can either produce 80 units of cloth or 50 units of wine. Let A consumes 40 units of cloth and 25 units of wine initially.

Similarly, with all available resources, country B can either produce 60 units of cloth or 20 units of wine. Let B consumes 30 units of cloth and 10 units of wine initially.

Here, country A has absolute advantage in the production of both the goods.

Here, trade will not be beneficial for both the countries as country A has absolute advantage in the production of both the goods.

For trade, we need to know the concept of comparative advantage.

Now, opportunity cost of producing cloth in country A = units of wine sacrificed/units of cloth produced = 50/80 = 0.625

and opportunity cost of producing wine in country A = units of cloth sacrificed/units of wine produced = 80/50 = 1.6

Similarly, opportunity cost of producing cloth in country B = units of wine sacrificed/units of cloth produced = 20/60 = 0.33

and opportunity cost of producing wine in country B = units of cloth sacrificed/units of wine produced = 60/20 = 3

As opportunity cost of producing cloth is lower for country B, country B has comparative advantage in the production of cloth.

Again, as opportunity cost of producing wine is lower for country A, country A has comparative advantage in the production of wine.

For trade, country A must specialize in wine production (i.e, 50 units of wine only), whereas, country B must specialize in cloth production (i.e, 60 units of cloth only).

Terms of trade must lie in the range : relative price in counttry A < TOT < relative price in country B

or, 1.6 units of cloth per unit of wine < TOT < 3 units of cloth per unit of wine

Let us suppose, exchange rate takes place at 2.5 units of cloth per unit of wine.

Under trade, country A will produce 50 units of wine only. If it consumes 25 units of it, it can export remaining 25 units of it to country B for which it will get 25*2.5 = 62.5 units of cloth in exchange. Compared to initial consumption (40 units of cloth and 25 units of wine), country A will gain 62.5-40 = 22.5 units of cloth from trade.

Similarly, under trade, country B will produce 60 units of cloth only. If it consumes 30 units of it, it can export remaining 30 units of it to country A for which it will get 30/2.5 = 12 units of wine in exchange. Compared to initial consumption (30 units of cloth and 10 units of wine), country B will gain 12-10 = 2 units of wine from trade.

The shift in consumption (from A to B) are shown below: