Question

Consider a Ricardian model where there are two goods: apples and bananas. For simplicity we will only consider one country called Alba (that is we will not think about its trading partner (or potential trading partner)). In Alba the unit labour requirement for an apple is 20 hours and for a banana is 10 hours. Alba has an endowment of 1000 hours of labour. Draw a production possibility frontier (PPF) diagram for Alba. Apples must be on the vertical axis and bananas must be on the horizontal axis. Suppose that if Alba does not allow its citizens to engage in international trade it will produce and consume 25 apples and it will produce and consume 50 bananas. Show this point on your diagram and label it PCA. Now suppose that Alba does allow its citizens to engage in international trade and the world price is 1 banana for 2 apples. Show on your diagram how many apples and how many bananas are produced in Alba; please label this point as PT. With international trade 80 apples and 60 bananas are consumed in Alba; please label this point as CT on the budget constraint. Finally, on your diagram label the quantity of exports and label the quantity of imports. On your diagram make sure that you state the quantities of exports and imports

Answer 1

In Alba the unit labour requirement for an apple is 20 hours and for a banana is 10 hours. Alba has an endowment of 1000 hours of labour.

If Alba decides to put all its labour in the production of apples, then the maximum apples that it can produce = total hours of labour/time taken to produce 1 apple = 1000/20 = 50

If Alba decides to put all its labour in the production of bananas, then the maximum bananas that it can produce = total hours of labour/time taken to produce 1 banana = 1000/10 = 100

If Apples are on the vertical axis and bananas on the horizontal axis, then the two points on the PPF of Alba are (0,50) and (100,0). PPF of Alba is plotted in figure 1.

If Alba produces and consumes 25 apples and 50 bananas, coordinates of Point PCA are (50,25). It is labelled as point PCA in figure 1.

Now suppose that Alba does allow its citizens to engage in international trade and the world price is 1 banana for 2 apples.

Opportunity cost of banana in Alba = slope of PPF = 1/2 apple

world price is 1 banana for 2 apples. So, the opportunity cost of 1 banana in world = 2 apples. (since price reflects the opportunity cost)

Since Alba has a lower opportunity cost of producing bananas, according to comparative advantage theory, it should specialize in the production of Bananas only. Therefore, bananas produced by Alba = 100 units. This has been marked as point PT in figure 1.

With international trade 80 apples and 60 bananas are consumed in Alba, this point (60,80) is labelled as CT in figure 1. Alba makes 100 bananas and then trade 40 bananas for 80 apples, consuming the remaining 60 bananas. So Alba exports 40 units of banana and imports 80 units of apples. Exports and imports are marked in figure 1.

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