Question

Given the following input-output table, answer questions a-h. Note that a one word answer is not acceptable. For full credit, you must provide explanation for your answers and show how you arrive at them.

                             Man Hour Required to Produce Unit of Output

                               Country A            Country B

                    Good X         3                    12

                    Good Y         2                    14

            a. Which country has absolute advantage in which good? Why?

            b. Which country has comparative advantage in which good? Why?

            c. What is the pre-trade price ratio in each country? Why?

            d. What will be the post-trade price ratio or international terms of trade?

            e. Which country would prefer an international terms of trade of 9? 6? Why?

            f. Let      W_A = wage rate in A in terms of A's currency

                        W_B = wage rate in B in terms of B's currency

                             R = exchange rate defined as number of units of B's currency per unit of                                    

               A's currency.

Then, in order to have balance of payments equilibrium, (W_A.R)/W_B must lie in some range, i.e., m < (W_A.R)/W_B < n.

               Determine the value of m and n.

            g. If W_A = 5, W_B = 2 and R = 3, which country will export which good?

h. Given that wages are fixed in each country at W_A = 5 and W_B = 2, what is the limit within which exchange rate can fluctuate in order for comparative advantage to

assert itself.

Answer 1

a. Absolute advantage is the ability of a country to produce a good or service at a lower cost per unit than the cost at which any other country produces that good or service. In the given scenario, Country A is able to produce Good X and Good Y by using less hours of labor as compared to Country B so, Country A has an absolute advantage over the production of good X and good Y.

b. A country has comparative advantage in producing a good if opportunity cost of producing that good is lower in that country as compared to other country.

In Country A:

Country can produce 3 units of good X or 2 units of good Y. If country want to produce one more unit of good X then, it has to sacrifice 0.67 i.e.(2/3rd unit of good Y) units of good Y. On the other hand, to produce one more unit of good Y, country has to sacrifice 1.5 units i.e. (3/2th unit of good X) of good X.

Opportunity cost of producing 1 more unit of good X = 0.67

Opportunity cost of producing 1 more unit of good Y = 1.5

Country B:

Country can produce 12 units of good X or 14 units of good Y. If country want to produce one more unit of good X then, it has to sacrifice 0.86 i.e.(12/14th unit of good Y) units of good Y. On the other hand, to produce one more unit of good Y, country has to sacrifice 1.17 units i.e. (14/12th unit of good X) of good X.

Opportunity cost of producing 1 more unit of good X = 0.86

Opportunity cost of producing 1 more unit of good Y = 1.17

Since, opportunity cost of producing good X is less in country A so, Country A has comparative advantage over the production of Good X. Similarly, opportunity cost of producing good Y is less in country B so, Country B has comparative advantage over the production of Good Y.

c. Country A:

Without trade: \frac{P_{X}}{P_{Y}}=\frac{3}{2} as without trade \frac{P_{X}}{P_{Y}}=\frac{a_{LX}}{a_{LY}} where aLX and aLY shows the unit labor requirement to produce good X and good Y in Country A.

Country B:

Without trade: \frac{P_{X}}{P_{Y}}=\frac{12}{14} as without trade \frac{P_{X}}{P_{Y}}=\frac{a_{LX}}{a_{LY}} where aLX and aLY shows the unit labor requirement to produce good X and good Y in Country B.