Question

In the table below we present the production possibility for two countries, A and B, who can both produce milk and soda. The number in the cell refers to the amount they can produce if they dedicated 100 per cent of their time to produce that good. So, country A can produce 40 litres of milk at most, and B can produce 20 litres of it at most.

Table – Production Possibility – 100 percent time on each product

Country	Milk	Soda
A	40	10
B	20	8

1. What is absolute advantage? Who has absolute advantage in milk and in soda?
2. What is opportunity cost? State the opportunity cost of each country for milk and soda.
3. What is comparative advantage? Who has comparative advantage in milk and in soda?
4. Can a country have comparative advantage in both products? Explain why.
5. Presently without specialization, each of them spends 50 per cent of their time producing milk and soda. Show how much each country is producing in a table. Suppose after specialization Country A spends 70 per cent of the time producing milk, while Country B spends 75 per cent of the time producing soda. Will they be better off by trading? What is the minimum price that Country B will accept for soda? What is the maximum price that Country A will pay for Soda? [Hint: the prices are not in Dollar terms but in terms of the other good]

Answer 1

1) Absolute advantage can be defined as the ability to carry out a particular economic activity more efficiently than another entity . Here country A has absolute advantage in both milk and soda ( produces more milk and soda than B )

2) Opportunity cost is the loss of another alternative when one alternative is chosen .

Country A opportunity cost of producing Milk = 1/4 soda

Country A opportunity cost of producing Soda = 4 Milk

Country B opportunity cost of producing Milk = 8 / 20 = 2/5 soda

Country B opportunity cost of producing Soda = 5/2 milk

3) Comparative advantage can be defined as the ability to carry out a particular economic activity (such as making a specific product) more efficiently than another activity . So the country with lower opportunity cost has comparative advantage .

Country B has comparative advantage in Soda ( 5/2 < 4)

Country A has comparative advantage in Milk ( 1/4 < 2/5 )

4) No a country cannot have CA in both products since it is a relative term . If it has CA in one good then obviously by finding the reciprocal we will see that the other country has CA in another .