2. Albert and Benjamin inhabit a two person world and they could only produce and consume...

2.
Albert and Benjamin inhabit a two person world and they could only produce and consume two goods: corn and sausage. They both face constant returns to scale. The table below shows the production possibilities for Albert and Benjamin if they are to fully specialize in each good only:
Albert Benjamin
Corn only 150 200
Sausage only 200 400

Originally Albert and Benjamin practices self-sufficiency and do not trade with each other. An economist proposes to Albert and Benjamin that they should end self-sufficiency and trade with each other. The economist proposes that Albert should specialize in sausage production and Benjamin should focus on corn production, and Albert should give Benjamin 100 sausage in exchange for 100 corn. Would the proposal make both Albert and Benjamin better off? Explain why yes or why not using the economic theories you have learnt?

Expert Solution

Solution:

The system of trading, and benefiting from the trade can be identified using concept of comparative advantage. A person/economy must specialize in the production of the good in which they have a comparative advantage. Which good gives comparative advantage to who can be found using opportunity cost.

Opportunity cost is the amount of one good given up in order to increase the production of the other good by one unit (in this sense, it is also the slope of a production possibility frontier). A person has comparative advantage in production of the good for which it has lower opportunity cost as compared to the other person.

Opportunity cost if producing corn = units of sausage produced/units of corn produced

Given the information, Albert can produce either 150 units of corn or 200 units of sausage. So, opportunity cost of producing corn:

For Albert = 200/150 = 1.33 sausages

Similarly, for Benjamin = 400/200 = 2 sausages

As the opportunity cost of producing corn is lower for Albert (1.33 < 2), Albert has comparative advantage in corn production. Correspondingly, Benjamin has comparative advantage in sausage production.

Thus, Albert should specialize in corn production and Benjamin should specialize in sausage production. So, no the proposal will not make any of them better off.

Furthermore, even the exchange rate mentioned is not beneficial even if specialization would have been proposed correctly. This is because exchange rate must lie within opportunity cost range. Proposal that 100 units of corn be exchanged for 100 units of sausage means one corn for one sausage. With the found out opportunity cost above, one corn must be exchanged for somwehere between 1.33 to 2 sausages, for both of them to be better off.

All in all, the mentioned proposal is not beneficial for any of them.

Rahul Sunny answered 2 years ago

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