Question

Sam can produce 6 donuts per hour or 18 cupcakes per hour. Milly can produce 3 donuts per day or 15 cupcakes per hour. Who has an absolute advantage in which product(s)? Find Sam’s opportunity costs for one donut and for one cupcake. Find Milly’s opportunity costs for one donut and for one cupcake. Sam has a comparative in which product(s)? Milly has a comparative advantage in which product(s)? Who should specialize in what product? What would be a mutually beneficial exchange rate?

Answer 1

Sam has an absolute advantage in producing donuts because he can produce more donuts by using same amount of resources than Mily.

And Sam also has an absolute advantage in producing cupcakes because he can produce more cupcakes by using same amount of resources than Mily.

Sam's opportunity cost for one donut= 18/6 = 3 cupcakes.

Sam's opportunity cost for one cupcake = 6/18= 0.33 donut.

Mily's opportunity cost for one donut = 15/3= 5 cupcakes.

Mily's opportunity cost for one cupcake= 3/15=0.2 donut.

Because Sam has a lower opportunity cost for donut and Mily has lower opportunity cost for cupcake , this implies that Sam has a comparative advantage in producing donuts and Mily has a comparative advantage in producing cupcakes.

Sam specializes in producing donuts and Mily specializes in producing cupcakes.

The mutually beneficially exchange rate would be when terms of trade lie between 3 cupcakes per donut and 5 cupcakes per donut . That is 4 cupcakes per donut is a mutually beneficially exchange rate.

Or in other words, when terms of trade lie between 0.2 donut per cupcake and 0.33 donuts per cupcake ,then this would be a mutually beneficial exchange rate.