Man Hour Required to Produce Unit of Output Country A Country B Good X 5 15 Good

Question

Man Hour Required to Produce Unit of Output

Country A Country B

Good X 5 15

Good Y 1 5

a. Which country has absolute advantage in which good? Why?

b. Which country has comparative advantage in which good? Why?

c. What is the pre-trade price ratio in each country? Why?

d. What will be the post-trade price ratio or international terms of trade?

e. Which country would prefer an international terms of trade of 5? 3? Why?

f. Let WA = wage rate in A in terms of A's currency

WB = wage rate in B in terms of B's currency

R = exchange rate defined as number of units of B's currency per unit of

A's currency.

Then, in order to have balance of payments equilibrium, (WA.R)/WB must lie in some range, i.e., m < (WA.R)/WB < n.

Determine the value of m and n.

g. If WA = 5, WB = 2 and R = 3, which country will export which good?

h. Given that wages are fixed in each country at WA = 5 and WB = 2, what is the limit within which exchange rate can fluctuate in order for comparative advantage to assert itself.

Explanation / Answer

a. Absolute advantage is the ability of a country to produce a good or service at a lower cost per unit than the cost at which any other country produces that good or service. In the given scenario, Country A is able to produce Good X and Good Y by using less hours of labor as compared to Country B so, Country A has an absolute advantage over the production of good X and good Y.

b. A country has comparative advantage in producing a good if opportunity cost of producing that good is lower in that country as compared to other country.

In Country A:

Country can produce 3 units of good X or 2 units of good Y. If country want to produce one more unit of good X then, it has to sacrifice 0.67 i.e.(2/3rd unit of good Y) units of good Y. On the other hand, to produce one more unit of good Y, country has to sacrifice 1.5 units i.e. (3/2th unit of good X) of good X.

Opportunity cost of producing 1 more unit of good X = 0.67

Opportunity cost of producing 1 more unit of good Y = 1.5

Country B:

Country can produce 12 units of good X or 14 units of good Y. If country want to produce one more unit of good X then, it has to sacrifice 0.86 i.e.(12/14th unit of good Y) units of good Y. On the other hand, to produce one more unit of good Y, country has to sacrifice 1.17 units i.e. (14/12th unit of good X) of good X.

Opportunity cost of producing 1 more unit of good X = 0.86

Opportunity cost of producing 1 more unit of good Y = 1.17

Since, opportunity cost of producing good X is less in country A so, Country A has comparative advantage over the production of Good X. Similarly, opportunity cost of producing good Y is less in country B so, Country B has comparative advantage over the production of Good Y

c.

Pre-trade price in country A = Px/Py = 5/1

Pre-trade price in country B = Px/Py = 15/5 = 3

d.

Post trade price ratio will be same for both country

as opportunity cost for producing 1 unit X by country A is 5 unit of y

but opportunity cost for producing 1 unit of X by country B is 3 unit of y

country B will specialize in X

country A will specialize in Y

post trade price ratio = px/py = 15/1

e.

term of trade = export/import

A prefer international terms of trade as 5

B prefer international terms of trade as 3

Because each country would prefer to have terms of trade as close as possible as their pre-trade price ratio

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