Question

Suppose Canada can produce 20 units of Oil and 0 units of potatoes if it chooses to only produce Oil. Otherwise, Canada can produce 50 potatoes and 0 units of oil if it only chooses to produce potatoes. The United States on the other hand can produce 25 units of oil (and 0 units of potatoes) if it choose to produce only oil and 100 units of potatoes and 0 units of oil if it chooses to produce only potatoes.

A.) What is the opportunity cost of 1 potato for the U.S.? For Canada?

B.) What is the opportunity cost of 1 oil for the U.S.? For Canada?

C.) Who has the absolute advantage in the production of Oil? Potatoes?

D.) Who has the comparative advantage in the production of Oil? Potatoes?

E.) Suppose the U.S. has decided to be self sufficient and is producing 10 units of oil and 40 units of potatoes. Is there anyway that the U.S. increase its consumption of goods outside its production possibilities frontier (for example, consume more potatoes without changing the consumption of oil)?

Answer 1

a)

Opportunity cost of 1 potato for the US=25/100=0.25 units of oil

Opportunity cost of 1 potato for the Canada=20/50=0.40 units of oil

b)

Opportunity cost of 1 oil for the US=100/25=4 units of potato

Opportunity cost of 1 oil for the Canada=50/20=2.50 units of potato

c)

Using equal amount of resources, US can produce more units of oil as compared to that Canada can produce. So, we can say that US has a absolute advantage in oil.

Similarly, using equal amount of resources, US can produce more units of potato as compared to that Canada can produce. So, we can say that US has a absolute advantage in potato also.

d)

We observe that US has a lower opportunity cost in potato production. So, we can say that US has a comparative advantage in potato production.

We also observe that Canada has a lower opportunity cost in oil production. So, we can say that Canada has a comparative advantage in oil production.

e)

Suppose both countries specialize as per comparative advantage i.e. US produces potato and canada produces oil. Trade can be beneficial if price of oil is between 2.5 units of potato and 4 units of potato. Let us say that price of oil is 3 units of potato.

US wants 10 units of oil. So, it has to export 30 units of potato in exchange with 10 units of oil. Now it has a 70 units of potato (100-30) and 10 units of oil.

We can see that US can consume more potato without changing the consumption of oil. So, specialization based upon comparative advantage can lead to increased consumption.