Question

ONLY F AND G

There are two countries, Lilliput and Blefuscu, which produce two goods: cilantro and hummus. In a single year, Lilliput can produce 4,000 tons of cilantro or 4,000 tons of hummus. In the same period of time, Blefescu can produce 500 tons of cilantro or 300 tons of hummus. Show your work as you answer these questions.

(a) Which country has absolute advantage in cilantro? (5%)
(b) Which country has absolute advantage in hummus? (5%)
(c) Which country has a comparative advantage in cilantro? (10%)
(d) Which country has a comparative advantage in hummus? (10%)
(e) Prior to trade, Lilliput makes 2,000 tons of cilantro, and Blefuscu makes 300 tons of cilantro. Draw these allocations on separate Production Possibilities Frontiers for each country. (10%)

(f) Considering the situation in (e), suppose that Lilliput gives Blefuscu 50 tons of hummus in exchange for 60 tons of coriander. Is this a beneficial trade for bothcountries? Use PPF diagrams to argue why or why not. (15%)
(g) Again considering the example in (e), what would be an example of a non-beneficial trade between the two countries? Show your work. (15%)

Answer 1

In the diagram below, we have shown PPF for Lilliput and Blefuscu.

a. Lilliput has absolute advantage in producing cilantro

b. Lilliput has absolute advantage in producing hummus

c. Blefuscu has comparative advantage in producing cilantro as opportunity cost of producing cilantro is lower

d. Lilliput has comparative advantage in hummus as opportunity cost of producing hummus is lower

e. On the diagram above, we have shown initial production for both countries as points a on both the PPF's. Before trade, Lilliput was producing and consuming 2,000 tons of cilantro and hummus each, whereas, Blefuscu was producing and consuming 300 tons of cilantro and 120 tons of hummus.

f. Terms of trade lies in the range 1 (4,000/4,000) ton of cilantro per ton of hummus and 1.67 (500/300) ton of cilantro per ton of hummus.

If exchange takes place at 60 tons of cilantro for 50 tons of hummus, i.e., 1.2 tons of cilantro per ton of hummus, then, trade is beneficial for both the countries.

Under trade, Lilliput will produce 4,000 tons of hummus only of which it will export 2,000 tons of it to Blefuscu, for which it gains 2,400 tons of cilantro.

Similarly, under trade, Blefuscu will produce 500 tons of cilantro only of which it will export 200 tons of it to Lilliput, for which it gains 250 tons of Hummus.

Thus, there is a gain of 400 (2,400-2,000) tons of cilantro and 130 (250-120) tons of hummus from trade.

The new consumption points are denoted as points b on the diagram above.

g. If exchange rate lies below 1, say, 0.5 ton of cilantro is exchanged per ton of hummus, then, for exporting 2,000 tons of hummus to Blefuscu, Lilliput will gain only 1,000 tons of cilatro. Thus, Lilliput will lose from trade. However, in this case, Blefuscu will gain from trade.

Again, if exchange rate lies above 1, say, 2 ton of cilantro is exchanged per ton of hummus, then, for exporting 200 tons of cilantro to Lilliput, Blefuscu will gain only 100 tons of hummus. Thus, Blefuscu will lose from trade. However, in this case, Lilliput will gain from trade.