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Paul and Tim inhabit a two person world and they could only produce and consume two...

Paul and Tim inhabit a two person world and they could only produce and consume two goods: cigars and oranges. They both face constant returns to scale. Below is a table that show the production possibilities for both Paul and Tim if they are to fully specialize in each good only:

Paul                 Tim

Cigars only                                                      50                    100

Oranges only                                                   200                  250

a. Who has an absolute advantage in producing cigars? Who has the comparative advantage in producing cigars?

b. Who has an absolute advantage in producing oranges? Who has the comparative advantage in producing oranges?

c. Predict the pattern of trade and the range of prices for which we could expect trade between Paul and Tim.

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Answer #1

(a) Since Tim can produce more cigars (100>50), Tim has an absolute advantage in Cigars.

Opportunity cost of cigars for Tim = 250/100 = 2.5

Opportunity cost of cigars for Paul = 200/50 = 4

Since, Tim has a lower opportunity cost, he has a comparative advantage in cigars

(b) Since Tim can produce more oranges (250>200), Tim has an absolute advantage in oranges.

Opportunity cost of oranges for Tim = 100/250= 0.4

Opportunity cost of oranges for Paul = 50/200 = 0.25

Since, Paul has a lower opportunity cost, he has a comparative advantage in oranges.

(c) Thus, the direction of trade is as follows: Time produces cigars and exports cigars to Paul. Paul produces oranges and exports oranges to Tim. The price of trade will be between 2.5 to 4 oranges per cigar

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