Question

Given the following input-output table, answer questions a-h. Note that a one word answer is not acceptable. 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

Answer -

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.