Question

3. Gains from trade

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

Country	Rye	Jeans
	(Bushels per hour of labor)	(Pairs per hour of labor)
Contente	8	16
Euphoria	5	20

Initially, suppose Contente uses 1 million hours of labor per week to produce rye and 3 million hours per week to produce jeans, while Euphoria uses 3 million hours of labor per week to produce rye and 1 million hours per week to produce jeans. Consequently, Contente produces 8 million bushels of rye and 48 million pairs of jeans, and Euphoria produces 15 million bushels of rye and 20 million pairs of jeans. 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 rye and jeans it produces.

Contente's opportunity cost of producing 1 bushel of rye is (1/2, 1/4, 2, 4) pairs   of jeans, and Euphoria's opportunity cost of producing 1 bushel of rye is (1/2, 1/4, 2, 4) pairs   of jeans. Therefore,(Euphoria/Contente) has a comparative advantage in the production of rye, and (Contente/Euphoria)   has a comparative advantage in the production of jeans.

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 rye will produce ______ million bushels per week, and the country that produces jeans will produce _____ million pairs 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 rye trades 18 million bushels of rye to the other country in exchange for 54 million pairs of jeans.

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 rye was 23 million bushels per week, and the total production of jeans was 68 million pairs per week. Because of specialization, the total production of rye has increased by _____ million bushels per week, and the total production of jeans has increased by ____ million pairs per week.

Because the two countries produce more rye and more jeans 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"). FILL IN GRAPH

	Contente		Euphoria
	Rye	Jeans	Rye	Jeans
	(Millions of bushels)	(Millions of pairs)	(Millions of bushels)	(Millions of pairs)
Without Trade
Production	8	48	15	20
Consumption	8	48	15	20
With Trade
Production	_____	____	_____	______
Trade action	(export 18/import 18)	(export 54/imort 54)	(export 18/import 18)	(exports 54/import 54)
Consumption	_______	________	________	________
Gains from Trade
Increase in Consumption	________	________	_______	________

Answer 1

Contente's opportunity cost of producing 1 bushel of rye is 2 pairs of jeans (=16/8), and Euphoria's opportunity cost of producing 1 bushel of rye is 4 pairs of jeans (=20/5). Therefore, Contente has a comparative advantage in the production of rye (lower opportunity cost), and Euphoria has a comparative advantage in the production of jeans.

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 rye will produce 32 million bushels per week (=4 x 8), and the country that produces jeans will produce 80 million pairs per week. (=4 x 20)

When the two countries did not specialize, the total production of rye was 23 million bushels per week, and the total production of jeans was 68 million pairs per week. Because of specialization, the total production of rye has increased by 9 million bushels per week, and the total production of jeans has increased by 12 million pairs per week.

	Contente		Euphoria
	Rye	Jeans	Rye	Jeans
Without trade
Production	8	48	15	20
Consumption	8	48	15	20
With trade
Production	32	0	0	80
Trade action
Consumption	14	54	18	26
Gains from trade
Increase in consumption	6	6	3	6

(All values are in mn)

(increase in consumption = change in consumption)