Question

America needs to use 100 hours of work to produce one unit of pen, while it needs to use 120 hours for work to produce one unit of eraser without being involved in the international trade. The American government decides to open its economy to the global market where the relative price of pen against eraser in 2/3. Which of the following options will be taken by America?

1. specialize in the production of pen and then export part of pen being produced in exchange for the import of eraser.

2. specialize in the production of eraser and then export part of pen being produced in exchange for the import of cloth.

3. remain in autarky

Answer 1

Opportunity cost

Opportunity cost is nothing but what you have to give up in order to get something else.

Quantity of erasers produced in 120 hours of work in America = 1

Quantity of erasers produced in 1 hours = 1/120

Quantity of erasers produced in 100 hours = 100/120

In this case, if America decided to produce 1 pen, it will take it 100 hours to produce that pen. However, the same 100 hours could be used to produce 100/120 quantity of eraser. Therefore, the opportunity cost of 1 pen in America is 100/120 units of eraser.

By the same argument, the opportunity cost of 1 eraser in America is 120/100 units of pen.

In other words, it can be said that the cost of producing 1 eraser in America is 120/100 units of pen.

Relative price

Relative price can be said as cost of purchasing a good in terms of other good.

In equilibrium, cost of purchasing a good should be equal to the cost of producing that good. Hence it can said that relative price is nothing but the opportunity cost of producing that good.

Given,

In global market, relative price of pen against eraser in 2/3. Hence, it can be said that in global market, opportunity cost of pen is 2/3. From this, opportunity cost of eraser in global market = 3/2 (revere of opportunity cost of pen)

In America, opportunity cost of pen is 100/120 = 5/6 erasers

In America, opportunity cost of eraser is 120/100= 6/5 pens

The country that has a lower opportunity cost in producing a good is said to have a comparative advantage in that good. And when trade occurs, a country with a lower opportunity cost produces that commodity.

Since, opportunity cost of America in producing pen (5/6) is higher than the opportunity cost of global markets in producing pen (2/3) , America should not produce pens.

But opportunity cost of America in producing eraser (6/5) is lower than the opportunity cost of global markets in producing eraser (3/2), therefore America should produce erasers and export them.

Therefore, America should specialize in the production of eraser and then export part of eraser being produced in exchange for the import of pen.

Option 1 is wrong since America should not produce pens.

Option 3 is wrong because it can earn some gains by exporting erasers, so it would not decide to be in autarky.

Option 2 is ( I think) misprinted, as there is no mention of cloth anywhere in the question. But since this is the only option that argues to export erasers, Option B is the right answer

Therefore, Option 2 is the right answer.