Suppose that country A and country B both produce wine and cheese. Country A has 800...

Suppose that country A and country B both produce wine and cheese. Country A has 800 units of available labor, while country B has 600 units. Prior to trade, country A consumes 40 pounds of cheese and 8 bottles of wine, and country B consumes 30 pounds of cheese and 10 bottles of wine.

Country A Country B

Labor per pound cheese 10 10

Labor per bottle wine 50 30

a. Which country has a comparative advantage in the production of each good? Explain.

b. Determine the production possibilities curve for each country, both graphically and algebraically. (Label the pretrade production point PT and the post-trade point P.)

c. Given that 36 pounds of cheese and 9 bottles of wine are traded, label the post-trade consumption point C.

d. Prove that both countries have gained from trade. e. What is the slope of the price line at which trade occurs?

Solutions

Expert Solution

a. Country A has a comparative advantage in production of cheese and country B has comparative advantage in the production of wine. This is because, Country A requires 50 units of labour to produce a bottle of wine and 10 units for a pound of cheese, thus one bottle of wine creates an opportunity cost of 5 pounds of cheese and for country B producing one bottle of wine creates an opportunity cost of 3 pounds of cheese. Since B has lower opportunity cost of producing wine, hence it has comparative advantage in the production of wine and A has comparative advantage in the production of a pound of cheese.

b. A has 800 units of labour. It takes 10 units of labour to produce a pound of cheese and 50 units of labour to produce a bottle of wine. If all the labour produces wine, 800/50 = 16 bottles of wine are produced and if only cheese is produced, 800/10 = 80 pounds of cheese is produced. Hence, PPF equaltion is 50w + 10c =800 where, w is bottles of wine and c is the pound of cheese produced.

Using the same logic, PPF equation for country B is 30w + 10c = 600

Graph for b and c part is attached in the image:

d. Both the countries are made better off with the trade as eveident from the diagram. The initial consumption point moved from initial IC point tangent with PPF to an outer IC in the region outside PPF. Hence, both countries are made better off by moving to a higher IC due to trade.

e. Terms of trade would be 36:9=4:1, that is Price of cheese is 1/4 of the price of wine.

Rahul Sunny answered 1 month ago

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