Question

2.

Albert and Benjamin inhabit a two person world and they could only produce and consume two goods: corn and sausage. They both face constant returns to scale. The table below shows the production possibilities for Albert and Benjamin if they are to fully specialize in each good only:

Albert              Benjamin

Corn only                                                        150                  200

Sausage only                                                   200                  400

Originally Albert and Benjamin practices self-sufficiency and do not trade with each other. An economist proposes to Albert and Benjamin that they should end self-sufficiency and trade with each other. The economist proposes that Albert should specialize in sausage production and Benjamin should focus on corn production, and Albert should give Benjamin 100 sausage in exchange for 100 corn. Would the proposal make both Albert and Benjamin better off? Explain why yes or why not using the economic theories you have learnt?

Answer 1

(Part I)

Opportunity cost (OC):

For Albert,

OC of corn = 200/150 = 1.33 sausage

OC of sausage = 150/200 = 0.75 corn

For Benjamin,

OC of corn = 400/200 = 2 sausage

OC of sausage = 200/400 = 0.5 corn

So, as per law of comparative advantage:

Albert can produce Corn at lower OC than Benjamin can, therefore, Albert should specialize in Corn (not in Sausage).

Benjamin can produce Sausage at lower OC than Albert can, therefore Benjamin should specialize in Sausage (not in Corn).

(Part II)

Trade is mutually beneficial when terms of trade ranges within the OC for both trading partners.

Acceptable terms of trade (TOT):

1.33 Sausage < TOT for 1 corn < 2 Sausage

The proposed trade ratio of 100 Sausage for 100 Corn signifies a TOT of 1, which falls outside the acceptable range and hence, is not mutually beneficial.