Question

Two countries are taking into consideration specializing in either olives or guns. If solely producing olives, country A can produce 300 and country B can produce 400 units. If solely producing guns, country A can produce 150 and country B can produce 100 units. Assume their labor forces are of equivalent size.

(a) Which country has the comparative advantage in olives and which country has the comparative advantage in guns?

(b) It is predicted that current demand will yield an exchange of 3 olives for every 1 gun. Will trade occur? If not, is it because both countries are against trade?

Answer 1

(a)

Opportunity cost of olives in country A = 150/300 = 0.5 guns

Opportunity cost of olives in country B = 100/400 = 0.25 guns

Since country B can produce olives at a lower opportunity cost, country B has comparative advantage in olives.

Accordingly, country A has comparative advantage in guns.

(b)

Opportunity cost of guns in country A = 300/150 = 2 olives

Opportunity cost of guns in country B = 400/100 = 4 olives

Trade is mutually beneficial if after-trade price lies between opportunity costs of trading partners. So acceptable price range is:

2 olives < 1 gun < 4 olives

Since given price lies within acceptable range, trade will occur.