In This Problem You Will Demonstrate Your Understanding of the Principles

question 11

Essay

In this problem you will demonstrate your understanding of the principles of comparative advantage. You will be given data that correspond to points on the production possibility curve of two countries. From this data, you will be asked to draw the graph of the production possibility curves. For simplicity, assume the production possibility curves of these countries are straight lines. To draw these production possibility curves you need only two points on your graph. A straight line connecting these points, and extended to the axes, will represent the production possibility curve.
(a) Country A and country B are potential trading partners. Each country produces two goods: fish and wine. If country A devotes all its resources to producing fish it can produce 1,000 fish, and if it devotes all its resources to producing wine, it can produce 2,000 bottles of wine. Draw the production possibility curve for country A. In country A, what is the opportunity cost of one bottle of wine in terms of fish?
(b) If country B devotes all its resources to producing fish it can produce 3,000 fish, and if it devotes all its resources to producing wine it can produce 3,000 bottles of wine. Draw the production possibility curve for country B. In country B, what is the opportunity cost of one bottle of wine in terms of fish?
(c) Do you see any possibility of gains from trade between these two countries? Does country A have any advantage in producing either wine or fish and trading for the other good? Is this advantage an absolute or a comparative advantage?
(d) Suggest a trade between these two countries which will make them both better off. Illustrate on their production possibility curves how this will make both countries better off, by allowing them to consume a mix of wine and fish that is outside their production possibility curves.

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