3. Gains from trade Consider two neighboring island countries called Dolorium an
ID: 1135741 • Letter: 3
Question
3. Gains from trade Consider two neighboring island countries called Dolorium and Contente. They each have 4 million labor hours available per month 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) Dolorium 5 20 Contente 8 16 Initially, suppose Contente uses 1 million hours of labor per month to produce rye and 3 million hours per month to produce jeans, while Dolorium uses 3 million hours of labor per month to produce rye and 1 million hours per month to produce jeans. Consequently, Dolorium produces 15 million bushels of rye and 20 million pairs of jeans, and Contente produces 8 million bushels of rye and 48 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. Dolorium's opportunity cost of producing 1 bushel of rye is of jeans, and Contente's opportunity cost of producing 1 bushel of rye is of jeans. Therefore, has a comparative advantage in the production of rye, and 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 producemillion bushels per month, and the country that produces jeans will producemillion pairs per month. 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 month, and the total production of jeans was 68 million pairs per month. Because of specialization, the total production of rye has increased bymillion bushels per month, and the total production of jeans has increased bymillion pairs per month. 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"). Dolorium Contente Rye Jeans Rye Jeans (Millions of bushels) (Millions of pairs) (Millions of bushels) (Millions of pairs) Without Trade Production 15 20 8 48 Consumption 15 20 8 48 With Trade Production Trade action Consumption Gains from Trade Increase in Consumption Grade It Now Save & Continue
Explanation / Answer
Output table when each country uses 4 million hours per good, is as follows.
Rye (Million)
Jeans (Million)
Dolorium
5 x 4 = 20
20 x 4 = 80
Contente
8 x 4 = 32
16 x 4 = 64
(1) Opportunity cost (OC)
In Dolorium, OC of Rye = 80/20 = 4 Jeans
In Contente, OC of Rye = 64/32 = 2 Jeans
(2) So,
Contente has comparative advantage in Rye (because OC of Rye is lower).
Dolorium has comparative advantage in Jeans.
(3)
Country making Rye (Contente) will produce 32 million Rye.
Country making Jeans (Dolorium) will produce 80 million Jeans.
(4) Because of specialization,
Production of Rye has increased by 9 million (= 32 million - 23 million).
Production of Jeans has increased by 12 million (= 80 million - 68 million).
(5) Dolorium trades (exports) 54 million Jeans in exchange of (imports) 18 million Rye. Contente trades (exports) 18 million Rye in exchange of (imports) 54 million Jeans.
DOLORIUM
CONTENTE
Jeans
Rye
Jeans
Rye
WITHOUT TRADE:
Prod. & Consumption
15
20
8
48
WITH TRADE
Production
0
80
32
0
Trade Action:
Import:
Export:
Export:
Import:
18 jeans
54 rye
18 jeans
54 rye
Consumption
18
26
14
54
GAIN FROM TRADE
Increase in Consumption
3
6
6
6
Rye (Million)
Jeans (Million)
Dolorium
5 x 4 = 20
20 x 4 = 80
Contente
8 x 4 = 32
16 x 4 = 64
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