Question

4. . Suppose the labor productivity per week in France and England are as follows:

                                    England                         France

  Wine                              30 bottles                     100 bottles

  Whiskey                         10 bottles                      20 bottles

I. Draw the production possibilities curve for both France and England

II. Which country has comparative advantage in whiskey? Which country has comparative advantage in wine? Why?

III. Which country will specialize in whiskey? Which country will specialize in wine?

IV. What will be the range of the terms of trade? With a hypothetical terms of trade, show the trade triangle.

V. Is there gain from trade for both France and England if they both specialize and trade?

Answer 1

It is given that, England and France has the following production abilities:

	England	France
Wine	30 bottles	100 bottles
Whiskey	10 bottles	20 bottles

Answer I:

Answer II: The Theory of Comparative Advantage states that if a country can produce goods at a lower opportunity cost compared to other country, it has comparative advantage in that commodity. The table of opportunity cost of one good measured in terms of other is given below:

	England	France
Wine	1 / 3 bottles of Whiskey	1 / 5 bottles of Whiskey
Whiskey	3 bottles of Wine	5 bottles Wine

France has comparative advantage in Wine.

France can produce 1 bottle of Wine by sacrificing only 1/5^th bottle of a Whiskey, while England can produce 1 bottle of Wine by sacrificing 1/3^rd bottles of Whiskey. Thus, France has a lower opportunity cost for (and comparative advantage in) Wine compared to England

England has comparative advantage in Whiskey.

England can produce 1 bottle of Whiskey by sacrificing only 3 bottle of a Wine, while France can produce 1 bottle of Whiskey by sacrificing 5 bottles of Wine. Thus, England has a lower opportunity cost for (and comparative advantage in) Wine compared to France.

Answer III: England will specialize in Whiskey. France will specialize in Wine.

[Reason: Countries should specialize in those commodities where they have a comparative advantage.]

Answer IV: The terms of trade means the relative prices in which the countries will engage in trade. For countries to trade and benefit from it, the terms of trade should strictly lie between the relative prices of the two countries before trade (i.e. in autarky).

The relative price of wine for England (P^E) is: P_wine / P_Whiskey = 1/3

The relative price of wine for France (P^F) is: P_wine / P_Whiskey = 1/5

Since, France has a lower relative price in wine than England, France would export wine to England (and import Whiskey from England). Let the world relative price at which trade occurs be P*.

Thus the range for terms of trade between the countries are:

Let the hypothetical terms of trade P* be 1/4. Thus, France would export 1 bottle of wine for 4 bottles of whiskey. Suppose initially France consumezs 10 bottles of whiskey and 50 bottles of wine. After trade, it consumes 8 bottles of whiskey and 98 bottles of wine. The trade triangle for France is shown below (between point A, 98 and 100):

Answer V: If both the countries specialize in trade, then England produces only Whiskey and France produces only wine. The theorem of Gains From Trade states that when countries engage in trade they both would gain from it if the world trade price lie between the auratky prices; provided they specialize in the commodities where they have a comparative advantage. Hence, there is gain from trade for both France and England if they both specialize and trade.