Question

On same graph, draw two Production Possibilitiies Frontiers : Company A can produce 10 buttons or 80 Tops. Company B can produce 100 buttons or 100 Tops. For both companies, points between limits is possible.

How can buttons and tops be greater with specialization? show on graph. Assume compnies trade 40 buttons for 20 tops. Demonstrate gains of trade w/points on graph

Answer 1

Company A can produce 10 buttons or 80 tops. Company B can produce 100 buttons or 100 tops.

Before trade, assume company A was producing 5 buttons and 40 tops whereas, company B was producing 50 buttons and 50 tops.

Opportunity cost of producing buttons for company A = 80/10 = 8 tops

Opportunity cost of producing tops for company A = 10/80 = 0.125 buttons

Opportunity cost of producing buttons for company B = 100/100 = 1 top

Opportunity cost of producing tops for company B = 100/100 = 1 button

As opportunity cost of producing buttons is lower for company B, company B has comparative advantage in production of buttons.

Again, as opportunity cost of producing tops is lower for company A, company A has comparative advantage in production of tops.

With specialization (for trade), company B must produce buttons only (100 buttons), whereas, company A must produce tops only (80 tops).

Terms of trade must lie in the range 0.125 buttons per top < TOT < 1 button per top.

If companies trade at 40 buttons for 20 tops i.e, 2 button per top, then only company A gains from trade.

Here, we have shown PPF for both the companies. Initially, company A is producing at point S and company B is producing at point P.

With trade, company A shifts from point S to point T (gets 80 buttons from exporting 40 tops). Thus, company A gains 80-5 = 75 buttons from trade.

However, company B shifts from point P to point Q (gets 25 tops from exporting 50 buttons). Thus, company B loses 25-50 = -75 tops from trade.