Question

Sam can produce either 60 bottles of wine or 40 loaves of bread per month. Dave can produce either 30

bottles or 30 loaves per month. (Each an also produce mixed combinations of bread and wine at

constant opportunity cost.)

Suppose they do not trade with one another when we first encounter them. Both are self-sufficient. Sam

produces and consumes 36 bottles of wine and 16 loaves of bread, while Dave produces and consumes

20 bottles of wine and 10 loaves of bread. These are both points on their respective production

possibility curves. (Note: the original problem had Sam producing 36 bottles and 14 loaves, which is a

point below his PPC – feasible but inefficient.)

Now: let each specialize in the good for which he has a comparative advantage and trade for the other

good. Suppose that each wants to consume the same amount of the good he specializes in producing as

he consumed before trade and trade the excess for as much of the other good as he can get. What terms

of trade will then be established: how much wine will be traded for how much bread? How much

bread and wine will each be consuming? Has trade made each better off?

Answer 1

	Wine(bottles)	Bread (loaves)
Sam	60	40
Dave	30	30

Sam's opportunity cost of wine = 40/60 = 0.66 loaves of bread

Dave's opportunity cost of wine = 30/30 =1 loaf of bread

Because Sam's opportunity cost is lower in producing wine . It implies that Sam has a comparative advantage in producing wine. Therefore, Sam specializes in wine prodiuction.

Similarly, Sam's opportunity cost of producing bread = 60/40 = 1.5 bottles of wine.

And Dave's opporunity cost of producing Bread = 30/30 = 1 bottle of wine.

Because Dave has lower opportunity cost of producing bread . It implies that Dave has a comparative advantage in producing bread. Therefore, Dave specialises in bread production.

Now, Sam will only produce wine i.e 60 bottles of wine. And Dave will only produce bread i.e 30 loaves of bread.

And before trade , Sam production and consumption of wine = 36 bottles of wine and 16 loaves of bread.

And before trade , Dave production and consumption of bread = 20 bottles of wine and 10 loaves of bread.

And Sam will consume the same bottles of wine i.e 36 after trade also. And Dave will consume same loaves of bread i.e 10 after trade also.

It implies that Sam will export (60-36)= 24 bottles of wine . And Dave will export (30-10)=20 loaves of bread. Therefore, terms of trade is 24 bottles of wine will be trade for 20 loaves of bread . The following table shows the gains from trade:

		SAM : Wine	Bread	DAVE: Wine	Bread
Before Trade	Production and Consumption	36	16	20	10
After trade	Production	60	0	0	30
	Trade	Exports 24	Imports 20	Imports 24	Exports 20
	Consumption	36	20	24	10
Gains from trade	Increase in consumption	0	4	4	0

Because there is increase in consumption , then both gains from trade and better off.