Question

Gains from trade

Consider two neighboring island countries called Euphoria and Contente. 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)
Euphoria	8	32
Contente	12	24

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, Euphoria produces 24 million bushels of rye and 32 million pairs of jeans, and Contente produces 12 million bushels of rye and 72 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.

Euphoria's opportunity cost of producing 1 bushel of rye is1/4 pair   of jeans, and Contente's opportunity cost of producing 1 bushel of rye is1/2 pair   of jeans. Therefore,Euphoria   has a comparative advantage in the production of rye, andContente   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 26 million bushels of rye to the other country in exchange for 78 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 36 million bushels per week, and the total production of jeans was 104 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”).

	Euphoria		Contente
	Rye	Jeans	Rye	Jeans
	(Millions of bushels)	(Millions of pairs)	(Millions of bushels)	(Millions of pairs)
Without Trade
Production	24	32	12	72
Consumption	24	32	12	72
With Trade
Production
Trade action
Consumption
Gains from Trade
Increase in Consumption

Answer 1

Euphoria's opportunity cost of producing 1 bushel of rye is 32/8 = 4 pairs of jeans and Contente's opportunity cost of producing 1 bushel of rye is 24/12 =2 pairs of jeans. Because Contente has a lower opportunity cost for the production of rye. Therefore, Contente has a comparative advantage in the production of rye 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 i.e Contente will produce (4)(12) = 48 million bushels per week And the country that produces jeans i.e Euphoria will produce 4(32)=128 million pairs per week.

Suppose the country that produces corn trades 26 million bushels of rye to the other country in exchange for 78 million pairs of jeans.

		EUPHORIA		CONTENTE
		Rye (millions of bushels)	Jeans (Millions of pairs)	Rye (Millions of bushels)	Jeans (Millions of pairs)
Without trade	Production	24	32	12	72
	Consumption	24	32	12	72
With Trade	Production	0	128	48	0
	Trade action	Import 26	Export 78	Export 26	Import 78
	Consumption	26	(128-78)= 50	(48-26)=22	78
Gains from trade	Increase in consumption	(26-24)=2	(50-32)= 18	(22-12)=10	(78-72)=6

When the two countries did not specialize ,the total production of rye was 36 million bushels per week and the total production of jeans was 104 millions pairs per week. Because of specialization ,the total production of rye was 48 million bushels per week and total production of jeans was 128 million pair per week.This implies that because of specialization , total production of rye has increased by (48-36)=12 million bushels per week and total production of jeans has increased by (128-104)=24 million pairs per week.