Question

The table below shows the production possibilities of two countries, X and Y, of two goods, A and B, given a fixed amount of resources and particular technology. (For country X: a worker can produce per month 78A or 26B. For country Y a worker can produce per month Y: 96A or 48B).

	A	B
X	78	26
Y	96	48

1. Which country has the absolute advantage in A, and which country has the absolute advantage in B? (1 Mark)

2. Calculate X’s opportunity cost of A in terms of B (1 Mark)

3. If the two countries were to specialize and trade with each other, indicate and explain which country would import A. (1Mark)

4. Assume the countries decide to specialize and trade and settled on a trading price of 2.5 A per B. Explain why the country that specializes in B would experience gains from trade. (1 Mark)

Answer 1

1) Absolute advantage refers to ability of a country to produce greater quantity of goods and services than competitors using the same amount of resources. It is determined by labour productivity. In the question, given table shows labour productivity on goods A & B per month.

So for both goods A and B country Y has an absolute advantage in production (96>78 and 48>26)

2) David Ricardo developed the classical theory based on comparative advantage. One has a comparative advantage over other if they can produce that good at relatively lower opportunity cost.  

For country X, opportunity cost of producing 78 A = 26 B

So opportunity cost of producing 1 A = 26/78 = 0.33 B

3) If two countries were to specialize and trade each other, then

So, by calculating opportunity costs (OC), we can find that country X has low opportunity cost in producing good A compared to country Y.

· According to comparative advantage theory each country will specialize in the production and export of those commodities in which it has the greatest advantage or the least comparative disadvantage. That is imports goods which has comparative disadvantage

· In other words countries will export item with lower opportunity cost & import item with higher opportunity cost

· So in this given case country Y will import good A from country X as it face more opportunity cost in producing the same

4) From the answer 3, if each country specialize in production of goods with less opportunity cost, then

Country X exports good A and country Y exports good B

Since the difference in opportunity cost in production of good A is very low compared to good B (0.17<1), the terms of trade will improve for the country that exports good B.

If the trade settled on a trading price of 2.5 A per B then both countries will gain because 2<2.5<3. That is for county Y, the opportunity cost for producing 1B is 2A and for country A, it is 3A.

If country Y gets 2.5 A per B, then it can get a maximum of 120 A (48*2.5) which is greater than 96

At the same time country X has to pay a price less than its opportunity cost before trade

Before trade, if they want to get 1B, they have to sacrifice 3A (That is sacrificing 26B cost them 78A (26*3), but after trade sacrificing the same amount will cost them only 65A (26*2.5)