Question

Gains from trade

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

	Jeans	Wheat
	(Pairs per hour of labor)	(kilograms per hour of labor)
Felicidad	5	20
Arcadia	4	8

Initially, suppose Arcadia uses 1 million hours of labor per month to produce jeans and 3 million hours per month to produce wheat, while Felicidad uses 2 million hours of labor per month to produce jeans and 2 million hours per month to produce wheat. Consequently, Felicidad produces 10 million pairs of jeans and 40 million kilograms of wheat, and Arcadia produces 4 million pairs of jeans and 24 million kilograms of wheat. 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 jeans and wheat it produces.

Felicidad's opportunity cost of producing one pair of jeans is   of wheat, and Arcadia's opportunity cost of producing one pair of jeans is   of wheat. Therefore,   has a comparative advantage in the production of jeans and   has a comparative advantage in the production of wheat.

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 jeans will produce   pairs per month, and the country that produces wheat will produce   kilograms per month. In the following table, enter each country's production decision on the second row of the table (marked "Production").

Suppose the country that produces jeans trades 11 million pairs of jeans to the other country in exchange for 33 million kilograms of wheat. 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 jeans was 14 million pairs per month and the total production of wheat was 64 million kilograms per month. Because of specialization, the total production of jeans has increased by   pairs per month, and the total production of wheat has increased by   kilograms per month. Because the two countries produce more jeans and more wheat 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").

	Felicidad		Arcadia
	Jeans	Wheat	Jeans	Wheat
	(Millions of pairs)	(Millions of kilograms)	(Millions of pairs)	(Millions of kilograms)
Without Trade
Production and consumption	10	40	4	24
With Trade
Production
Trade Action
Consumption
Gains from Trade
Increase in consumption

Answer 1

They each have 4 million labor hours available per month

	Jeans	Wheat
	(Pairs per hour of labor)	(kilograms per hour of labor)
Felicidad	5	20
Arcadia	4	8

Felicidad's opportunity cost of producing one pair of jeans is 20/5 = 4 kgs of wheat, and Arcadia's opportunity cost of producing one pair of jeans is 8/4 = 2kgs of wheat. Therefore, Arcadia has a comparative advantage in the production of jeans and Felicidad has a comparative advantage in the production of wheat.

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 jeans will produce 4*4 = 16 pairs per month, and the country that produces wheat will produce 20*4=80 kilograms per month.

When the two countries did not specialize, the total production of jeans was 14 million pairs per month and the total production of wheat was 64 million kilograms per month. Because of specialization, the total production of jeans has increased by 16-14 = 2 pairs per month, and the total production of wheat has increased by 80-64 = 16 kilograms per month

Suppose the country that produces jeans trades 11 million pairs of jeans to the other country in exchange for 33 million kilograms of wheat.

.

	Felicidad		Arcadia
	Jeans	Wheat	Jeans	Wheat
	(Millions of pairs)	(Millions of kilograms)	(Millions of pairs)	(Millions of kilograms)
Without Trade
Production and consumption	10	40	4	24
With Trade
Production	0	80	16	0
Trade Action	Imports 11	Exports 33	Exports 11	Imports 33
Consumption	11	80-33 = 47	16-11 = 5	33
Gains from Trade
Increase in consumption	11-10 =1	47-40 = 7	5-4 =1	33-24 = 9