Question

3. Gains from trade

Consider two neighboring island countries called Dolorium and Arcadia. 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
Arcadia	8	16

Initially, suppose Arcadia 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 Arcadia 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 Arcadia'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		Arcadia
	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

Answer 1

Dolorium's opportunity cost of producing 1 bushels of rye is 20/5=4 pairs of jeans and Arcadia's opportunity cost of producing 1 bushel of rye is 16/8=2 pairs of jeans. Because Arcadia has a lower opportunity cost for the production of rye. Therefore, Arcadia has a comparative advantage in the production of rye and Dolorium 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 i.e Arcadia will produce (4)(8) = 32 million bushels per month And the country that produces jeans i.e Dolorium will produce 4(20)=80 million pairs per month.

Suppose the country that produces rye trades 18 million bushels of rye  to the other country in exchange for 54 million pairs of jeans.

		DOLORIUM		ARCADIA
		Rye (milions of bushels)	Jeans (Millions of pairs)	Rye (Millions of bushels)	Jeans (Millions of pairs)
Without trade	Production	15	20	8	48
	Consumption	15	20	8	48
With Trade	Production	0	80	32	0
	Trade action	Import 18	Export 54	Export 18	Import 54
	Consumption	18	(80-54)=26	(32-18)=14	54
Gains from trade	Increase in consumption	(18-15)=3	(26-20)=6	(14-8)=6	(54-48)=6

When the two countries did not specialize ,the total production of rye was 23 million pairs per month and the total production of jeans was 68  millions pairs per month. Because of specialization ,the total production of rye was 32 million bushels per month and total production of jeans was 80 million pairs per month. This implies that because of specialization , total production of rye has increased by (32-23)=9 million bushels per month and total production of jeans has increased by (80-68)=12 million pairs per month.