Question

3. Gains from trade

Consider two neighboring island countries called Arcadia and Dolorium. They each have 4 million labor hours available per week that they can use to produce jeans, rye, or a combination of both. The following table shows the amount of jeans or rye that can be produced using 1 hour of labor.

Country	Jeans	Rye
	(Pairs per hour of labor)	(Bushels per hour of labor)
Arcadia	6	12
Dolorium	4	16

Initially, suppose Arcadia uses 1 million hours of labor per week to produce jeans and 3 million hours per week to produce rye, while Dolorium uses 3 million hours of labor per week to produce jeans and 1 million hours per week to produce rye. Consequently, Arcadia produces 6 million pairs of jeans and 36 million bushels of rye, and Dolorium produces 12 million pairs of jeans and 16 million bushels of rye. Assume there are no other countries willing to trade goods, so, in the absence of trade between these two countries, each country consumes the amount of jeans and rye it produces.

Arcadia's opportunity cost of producing 1 pair of jeans is of rye, and Dolorium's opportunity cost of producing 1 pair of jeans is   of rye. Therefore,   has a comparative advantage in the production of jeans, and   has a comparative advantage in the production of rye.

Suppose that each country completely specializes in the production of the good in which it has a comparative advantage, producing only that good. In this case, the country that produces jeans will produce million pairs per week, and the country that produces rye will produce million bushels per week

In the following table, enter each country's production decision on the third row of the table (marked "Production").

Suppose the country that produces jeans trades 14 million pairs of jeans to the other country in exchange for 42 million bushels of rye.

In the following table, select the amount of each good that each country exports and imports in the boxes across the row marked "Trade Action," and enter each country's final consumption of each good on the line marked "Consumption."

When the two countries did not specialize, the total production of jeans was 18 million pairs per week, and the total production of rye was 52 million bushels per week. Because of specialization, the total production of jeans has increased by million pairs per week, and the total production of rye has increased by

million bushels per week.

Because the two countries produce more jeans and more rye under specialization, each country is able to gain from trade.

Calculate the gains from trade—that is, the amount by which each country has increased its consumption of each good relative to the first row of the table. In the following table, enter this difference in the boxes across the last row (marked "Increase in Consumption").

	Arcadia		Dolorium
	Jeans	Rye	Jeans	Rye
	(Millions of pairs)	(Millions of bushels)	(Millions of pairs)	(Millions of bushels)
Without Trade
Production	6	36	12	16
Consumption	6	36	12	16
With Trade
Production
Trade action
Consumption
Gains from Trade
Increase in Consumption

.

Answer 1

First, we compute the Output table when each country uses 4 million hours per good.

	Jeans (Million)	Rye (Million)
Arcadia	6 x 4 = 24	12 x 4 = 48
Dolorium	4 x 4 = 16	16 x 4 = 64

(1) Opportunity cost (OC)

In Arcadia, OC of Jeans = 48/24 = 2 rye

In Dolorium, OC of Jeans = 64/16 = 4 rye

(2) So,

Arcadia has comparative advantage in Jeans (because OC of Jeans is lower).

Dolorium has comparative advantage in Rye.

(3)

Country making Jeans (Arcadia) will produce 24 million Jeans.

Country making Rye (Dolorium) will produce 64 million Rye.

(4) Because of specialization,

Production of Jeans has increased by 6 million (= 24 million - 18 million).

Production of Rye has increased by 12 million (= 64 million - 52 million).

(5) Arcadia trades (exports) 14 million Jeans in exchange of (imports) 42 million Rye. Dolorium trades (exports) 42 million rye in exchange of (imports) 14 million jeans.

	ARCADIA		DOLORIUM
	Jeans	Rye	Jeans	Rye
WITHOUT TRADE:
Prod. & Consumption	6	36	12	16
WITH TRADE
Production	24	0	0	64
Trade Action:	Export:	Import:	Import:	Export:
	14 Jeans	42 Rye	14 Jeans	42 Rye
Consumption	10	42	14	22
GAIN FROM TRADE
Increase in Consumption	4	6	2	6