Question

1. Answer the following questions concerning trade between England and Portugal. This scenario follows the first example given by an economist about Comparative Advantage written in 1817. You may answers the questions in the text box provided, op answer them on a document you save to your own computer and attach to this assignment, or make a pdf of your handwritten answers and attach them below. (If you use an Apple computer, please save your .pages document as a Word document (.doc) or your .numbers document as an Excel document (.xls). I cannot open .pages or .numbers documents.)

Written Homework #1

Using the data in the table, answer the following questions:

(a) For which good does England have a comparative advantage? Explain your answer.

(b) For which good does Portugal have a comparative advantage? Explain your answer.

(c) If specialization and trade occurred, what might be an exchange rate between the two goods that would be mutually beneficial to both countries?

(d) Prove that both countries would be better off in the specialization-trade case than in the no specialization–no trade case. Use a PPF for each country separately to prove this showing the PPF before trade and the PPF available after trade if the mutually beneficial exchange rate were in place.

                Points on

               Production                              England                               Portugal

      Possibilities Frontier           Cloth                 Wine               Cloth              Wine

                       A                               60                       0                     80                     0

                       B                               48                     10                     64                    18

                       C                               36                     20                     48                    36

                       D                               24                     30                     32                    54

E 12 40 16 72

F 0 50 0 90  

Answer 1

(a) Comparative advantage is defined as having lower opportunity cost of production compared to another country.

To find the Comparative advantage for England we need to find the opportunity cost of production in both the countries of both goods and then compare it.

Let's first calculate the opportunity cost of production in England.

The opportunity cost of wine, =60/90 = 2/3. That is to produce 1 unit of wine England must give up 2/3 units of cloth.

Opportunity cost of producing cloth in England.

=90/60=3/2

=1.5 that is to produce 1 unit of cloth England must give up 1.5 units wine.

Now let's calculate the opportunity cost of production in Portugal.

Opportunity cost of producing wine.

=80/50= 8/5 that is to produce 1 unit of wine Portugal must give up 8/5 units of cloth.

Opportunity cost of producing cloth.

= 50/80= 5/8 that is to produce 1 unit of cloth Portugal must give up 5/8 units of wine.

England has lower opportunity cost of producing wine as compared to Portugal, and hence England has Comparative advantage in the production of wine.

(b) As we can see above the opportunity cost of producing cloth is lower in Portugal as compared to England.

Hence Portugal has Comparative advantage in the production of cloth.

(C) According to the international trade model of comparative advantage the countries will specialize in the production of good in which it has a Comparative advantage. Thus England will specialize in the production of wine while Portugal will specialize in the production of cloth.

For the trade to be mutually beneficial the exchange must be such that which is mutually beneficial such that it's less costly to produce good indirectly through trade as compared to producing on its own.

The domestic exchange rate for 1 unit of wine in Portugal is 8/5 units of cloth while in England it is 2/3 units of cloth. And similarly the domestic exchange rate for cloth is 3/2 units of wine in England and 5/8 units of wine in Portugal.

If the exchange rate is set to 1, that is for 1 unit of cloth country can trade 1 unit of wine. This will be mutually beneficial for both the countries.

At this exchange rate Portugal can trade wine for cloth at cheaper rate and at the same time England can trade cloth for wine at cheaper rate. So it's beneficial for both of them.

(d) In this part we need to show the impact of specialization and trade on the production possibilities of both the countries. Below I have drawn the PPF of the both the countries before and after trade.

The dotted line is the production possibility frontier that a country faces in case specialization and trade. As you can see if they trade their production possibility shifts outwards in the direction of good in which they don't have Comparative advantage. Showing it's best for both the countries to produce good in which they have Comparative advantage.