The following table illustrates the number of labour hours required by France an

Question

The following table illustrates the number of labour hours required by France and Chile to produce a bottle of wine and a lbs of chocolate:

Wine Chocolate

France 80 25

Chile 50 15

(a) Which country has absolute advantage in the production of wine? Which country has absolute advantage in the production of chocolates? Clearly explain you answer. (5 points)

(b) Which country has comparative advantage in the production of wine? Which country has comparative advantage in the production on chocolates? Clearly explain and show all appropriate calculations. (5 points)

(c) If transportation costs are ignored and trade is allowed, should France and Chile engage in trade? (You don’t have to calculate the numbers, just state whether trade will be mutually beneficial.) If France and Chile engage in trade, what specific ‘terms of trade’ should they use to realize mutually beneficial gains. (10 points)

(d) Based on the notions of absolute and comparative advantage and the terms of trade, illustrate a trade scheme that will benefit both countries. You should provide all relevant calculations and illustrate your answer using a well-labeled graph. (5 points)

Explanation / Answer

(a) Absolute advantage is the ability of a country to produce more quantity of good using the same resources. France has absolute advantage in the production of wine because it is able to produce 80 units irrespective of 50 units produced by Chile by using the same number of labor hours.

Similarly, France also has absolute advantage in the production of chocolates because France is able to produce more units of chocolates as compared to Chile by using same number of labor hours.

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

Opportunity cost of producing Wine and Chocolate in France:

80 units of Wine = 25 units of Chocolate

1 unit of Wine = 25/80 units of chocolate

1 unit of Wine = 0.3125 units of Chocolates

Similarly, 1 unit of Chocolate = 80/25 units of Wine

1 unit of Chocolate = 3.2 units of Wine

Opportunity cost of producing one unit of wine in France is 0.3125 units of chocolates while opportunity cost of producing 1 unit of chocolate is 3.2 units of wine.

Opportunity cost of producing Wine and Chocolate in Chile:

50 units of Wine = 15 units of Chocolate

1 unit of Wine = 15/50 units of chocolate

1 unit of Wine = 0.3 units of Chocolates

Similarly, 1 unit of Chocolate = 50/15 units of Wine

1 unit of Chocolate = 3.33 units of Wine

Opportunity cost of producing one unit of wine in Chile is 0.3 units of chocolates while opportunity cost of producing 1 unit of chocolate is 3.33 units of wine.

Since, opportunity cost of producing 1 unit of wine is less in Chile so Chile has comparative advantage in the production of wine. On the other hand, opportunity cost of producing 1 unit of chocolate is less in France so France has comparative advantage in the production of chocolate.

(c) Yes, if transportation costs are ignored then France and Chile engage in trade. France will export chocolates to Chile while Chile export units of wine because they have their comparative advantage in the production of these goods.

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