Opportunity Costs and Trade conditions

External question — Economics Stack Exchange Author: Hypnos123 Original post: https://economics.stackexchange.com/questions/57836 License: CC BY-SA 4.0 — https://creativecommons.org/licenses/by-sa/4.0/ Adaptation: HTML converted to plain text; contact email addresses removed. A and B can both bake cakes or grow carrots such that they are each self sufficient, or they can each specialize in one activity and trade between themselves. Cakes and carrots are both desirable for both people. A spends 10 hours in a day and can bake 5 cakes or spends the same 10 hours and grows 25 carrots, while B spends 10 hours to bake 4 cakes or to grow 44 carrots. Which of the following is a specialization according to comparative advantage and an agreeable trade between both of them? Select one: a. A bakes 5 cakes and gives 2 of them to B in exchange for 13 carrots from him B grows 44 carrots and gives 22 of them to A in exchange for 1 cake from him B grows 44 carrots and gives 22 of them to A in exchange for 1.5 cakes from him A bakes 5 cakes and gives 1 of them to B in exchange for 13 carrots from him I understand that the first stop calculating the opportunity costs for the two and then looking for a trade term between the two. That would imply that the answer is 1, but some sources I’ve consulted say that the answer is 4.

External answer — Economics Stack Exchange Author: pragya shankar Original post: https://economics.stackexchange.com/a/59556 License: CC BY-SA 4.0 — https://creativecommons.org/licenses/by-sa/4.0/ Adaptation: HTML converted to plain text; contact email addresses removed. In which activity should A and B specialize for agreeable trade? Key Terms: Comparative Advantage(CA), Opportunity Costs(OCs), Specialization, GFT. (Ricardian Model) CA determines Trade Conditions: Which goods to produce where, pattern of trade, and existence of gains from trade (GFT). Data generates following One-Factor Ricardian Model: 2 Individuals, A and B 2 Goods(Activities), Cake (C) and Carrots (Cr) One Input (Factor), Labour (Picture Below)) CA Calculations (Measured by OCs): OC 1 Cake, A= 5 Carrots; OC 1 Cake, B= 11 Carrots A: CA in Cake- OC of Cake lower in terms of Carrots vs. B (5 vs. 11) B: CA in Carrots (Converse). (Note: Absolute Advantage: A in Cake, B in Carrots) Trade conditions (Trade in the One-Factor Model): • Differences in Autarky Relative Price of Cake in A and B create an opportunity for trade: A: Will want to export Cake- PC/PCr = OC Cake (A) = 5 <P*C/P*Cr = OC of Cake (B) = 11. B: Will want to export Carrots (converse) PCr/PC= OC Carrots (A) = 1/5 > P*C/P*Cr = OC of Carrots (B)=1/11. • Free trade prices converge to rule out arbitrage- Cake and Carrot will cost the same for A and B: 5 ≤ PTC/PTCr ≤ 11 (Superscript T stands for Trade) Relative prices determined by Relative supply and Relative Demand Curves. • Relative wages post-trade: (PTC*MPLC)/(PTCr*MPLCr) • Trade is balanced: Exports(X) = Imports(IM), in both Goods. • Gains from Trade: Means more production and more consumption. Due to: (i) Gains from Specialization (ii) Gains from Exchange (It’s the result of specialization according to comparative advantage). Option 1 is the right answer: A exchanges 2 Cakes for 13 Carrots from B. Other options are unprofitable for B. Trade Conditions under Option 1: • Relative Price: 5 <PTC/PTCr = 6.5 <11 • Relative Wages: A: (PTC/PTCr)*(MPLC/MPLCr) = 6.5*(0.5/2.5) = 1.3 > 1. Wages higher in Cake than Carrots B: (PTC/PTCr)*(MPLC /MPLCr) = 6.5*(0.4/4.4) = 26/44 < 1. Wages higher in Carrots than Cake. • Specialization: A- Cake (Complete), B- Carrots (Complete). • Trade Patterns: A exports Cake, B exports Carrots, 1 Cake=6.5 Carrots. • Gains from Trade (GFT): (a) Autarky Eqm (Tangency of IC with PPF): Assume this is at the mid- point of the PPF of both countries. A:(2.5,12.5), B at (2,22) (Production= Consumption on PPF) (b) Post Trade, Production, Exchange and Consumption occur along the Trade Possibility Frontier (TPF) for A and B: Production: A: 5C, 0Cr; B: 0C, 44Cr Consumption: A: 3C, 13Cr; B: 2C, 31Cr. (c) GFT (Comparison with Autarky): Production Consumption A: +2.5C, -12.5Cr +0.5C, +0.5Cr B: -2C, +22Cr 0 C, +9Cr Total: +0.5C, +9.5Cr +0.5C, +9.5Cr (Picture Below) Note: It is possible that total output might not rise for both goods upon specialization. In this case, it cannot be made sure that both countries would gain from trade (Eg. Large Country trading with Small country). This depends on the relationship between wages and prices. References: ( https://www.colorado.edu/faculty/kmaskus/sites/default/files/attached-files/notes3-ricardian.pdf ) 2( https://www.princeton.edu/~dixitak/Teaching/InternationalTrade/Slides/ECO352_05.pdf ) Chapter 2, International Economics: Theory and Policy, Paul R. Krugmann and M. Obstfeld, 6th Edition. Chapter 2, International Economics, Robert C. Feenstra and Alan M. Taylor, 3rd Edition. net/md1gS8LD.png