Suppose that two people, Michelle and James each live alone in an isolated regio

Question

Suppose that two people, Michelle and James each live alone in an isolated region. They each have the same resources available, and they grow potatoes and raise chickens. If Michelle devotes all her resources to growing potatoes, she can raise 200 pounds of potatoes per year. If she devotes all her resources to raising chickens, she can raise 50 chickens per year. (If she apportions some resources to each, then she can produce any linear combination of chickens and potatoes that lies between those extreme points. If James devotes all his resources to growing potatoes, he can raise 80 pounds of potatoes per year. If he devotes all his resources to raising chickens, he can raise 40 chickens per year. (If he apportions some resources to each, then he can produce any linear combination of chickens and potatoes that lies between those extreme points.)



Potatoes
Chickens

Michelle
200
50

James
80
40


•What is Michelle’s opportunity cost of producing potatoes?
•What is Michelle’s opportunity cost of producing chickens?
•What is James’ opportunity cost of producing potatoes?
•What is James’ opportunity cost of producing chickens?
•Which person has an absolute advantage in which activities?
•Which person has comparative advantage in potatoes?
•Which person has comparative advantage in chicken?
•Suppose that they are thinking of each specializing completely in the area in which they have a comparative advantage, and then trading at a rate of 2.5 pounds of potatoes for 1 chicken, would they each be better off? Explain.
•How would you extend the above narrative to businesses, society as a whole or nations? Explain.

Explanation / Answer

•What is Michelle’s opportunity cost of producing potatoes? 4 chickens for every one potato (200 divided by 50) •What is Michelle’s opportunity cost of producing chickens? .25 potatoes for every chicken (50 divided by 200) •What is James’ opportunity cost of producing potatoes? 2 chickens for one potato (80 divided by 40) •What is James’ opportunity cost of producing chickens? .5 potatoes for every chicken (40 divided by 80) •Which person has an absolute advantage in which activities? Michelle has an absolute advantage in producing both potatoes and chickens, because she can make more of both than James can, given the same resources •Which person has comparative advantage in potatoes? James does, because it costs him only 2 chickens to produce one potato, while it costs Michelle 4 chickens to produce one potato. •Which person has comparative advantage in chicken? Michelle does, because it only costs her .25 potatoes to produce a chicken, while it costs James .5 potatoes. •Suppose that they are thinking of each specializing completely in the area in which they have a comparative advantage, and then trading at a rate of 2.5 pounds of potatoes for 1 chicken, would they each be better off? Explain. No they wouldn’t each be better off; James’ opportunity cost for producing a chicken is .5 potatoes, so with this rate he would be spending 2.5 potatoes per chicken, rather than .5 potatoes per chicken. Michelle, on the other hand, would benefit, because her opportunity cost for producing one potato is 4 chickens, so with this trade, she would be getting potatoes at a lower comparative rate. •How would you extend the above narrative to businesses, society as a whole or nations? Explain. While trade can be extremely beneficial to two individuals, parties, or nations, it does not always make sense to trade at a given rate. It is not enough to say that two nations have comparative advantages in two separate products, so they should trade. The terms of the trade should benefit both parties—they should be getting better deals than what they could do on their own—to make the trade worthwhile for both of them. To give an example, let’s say the US has a comparative advantage over Japan in making burgers, while Japan has a comparative advantage over the US in making computers. A trade could benefit both countries in this instance. However, if Japan is suggesting a rate of two million burgers for one computer, it is not in the US’s best interest to trade; the US can make computers for less than two million burgers each.

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