Question

1(a) Give a numerical example which illustrates how a country could have absolute disadvantage in the production of 2 goods but could still have a comparative advantage in the production of one of them. Explain!

(b)    Explain how the process of arbitrage could achieve Purchasing Power Parity?

Answer 1

a. Let us consider two countries India and Pakistan. Let us assume that the two counties can produce the following amounts of good using 1 man hour of labor.

	Wheat	Cloth
India	10	8
Pakistan	6	3

Clearly, India has an absolute advantage in the production of both the goods. On the other hand, India is 10÷6= 1.67 times more efficient than Pakistan in the production of wheat and 8÷3 = 2.67 times more efficient than Pakistan in the production of cloth.

On the other hand, we can observe that Pakistan is 6÷10= 0.6 times efficient in the production of wheat and 3÷8= 0.376 times efficient in the production of cloth.

Thus, We can observe that India has a comparative advantage in the production of cloth and Pakistan has comparative advantage in the production of wheat.

Hence, the statement is proved.

b. Purchasing power parity theory says that the value of two currencies is equal when a basket of identical goods is priced the same in both countries. It ensures that the buyers have the same purchaing power over global markets.

However, in reality, the purchasing power parity is difficult to achieve due to various costs in trading and the inability of some individuals to access markets.

If the price of any economic good or security is inconsistent in two different free markets after considering the effects of currency exchange rates, then to earn a profit, an arbitrageur will purchase the asset in the cheaper market and sell it in the market where prices are higher. Arbitrage profits such as these will persist until the price converges across markets.

This way the process of arbitrage could achieve purchasing power parity.