Advanced Business Economics
Term 2
Seminar 1
1- Assume a classical world of two goods and two countries where labour is the only factor of
production. The table below shows the outputs of cloth and wheat one day of labour will
produce in countries A and B.
Country A
Country B
Cloth (square meters)
20
4
Wheat (Kilograms)
30
5
a. Calculate the opportunity cost of producing cloth in each country
In Country A, to produce 20 units of cloth the economy has to forgo 30 units of wheat.
The opportunity cost of 1 unit of cloth is 1.5 units of wheat.
To produce 4 units of cloth, country B has to sacrifice5 units of wheat. The opportunity
cost of 1 unit of cloth is 1.25 units of wheat.
b. What pattern of absolute and comparative advantage exists? Explain your answer
Country A has an absolute advantage in both industries. Country A can produce more
cloth and more wheat with one unit of labour compared to country B. Country B has a
comparative advantage in the production of cloth. The opportunity cost of producing
cloth is lower in country B compared to country A. Country A has a comparative
advantage in the production of wheat. In country A the opportunity cost of wheat is
2/3 while in country B the opportunity cost of wheat is 0.8.
c. If the international trade relative price of cloth is 1.4, explain how each country gains
from trade.
The international price falls between the two autarky prices in each country. This is a
result of international trade where country B specialises in Cloth (export Cloth) and
country A specialises in Wheat. In each country, the relative price of the exported good
increases. Since workers receive a competitive wage, this translates into higher wages
for the workers in each country (all will be working in one industry; Cloth in B and
Wheat in A). In each country, the relative price of the imported product will fall. This
means that real wages will increase. Production possibilities increase because each
country uses its resources more efficiently.
2- Suppose that each worker in the home country can produce three cars or two TVs. Assume
that Home has four workers.
a. Graph the production possibilities frontier for the Home country.
Tvs
8
12
Cars
b. What is the no-trade relative price of cars at Home?
To produce 3 cars, Home needs to sacrifice 2 TVs. The opportunity cost of cars at home
is 2/3. In the absence of trade, consumers in home will wish to consume both goods.
Home will produce both goods only if the wage is equal across the two industries.
Otherwise, workers will prefer to work in the industry offering the highest wage.
Workers are paid competitive prices that reflect their productivity.
Let Pc be the price of cars and Pt the price of TVs, Wc the wage in the car industry and
Wt the wage in the TV industry. A worker in the car industry will earn Wc=3Pc, and a
worker in the TV industry will earn Wt=2Pt. The wage will be equal in both industries
when the relative price of cars (Pc/Pt) is equal to the opportunity cost of cars (2/3).
3- Suppose that each worker in the Foreign country can produce two cars or three TVs. Assume
that Foreign also has four workers.
a. Graph the production possibility frontier for the Foreign country.
Tvs
12
8
Cars
b. What is the no-trade relative price of cars in Foreign.
To produce 2 cars, Home needs to sacrifice 3 TVs. The opportunity cost of cars at home
is 1.5. In the absence of trade, the relative price of cars (Pc/Pt)* is equal to the
opportunity cost of cars (1.5).
c. Using the information provided in problem 3 regarding Home, in which good does
Foreign have a comparative advantage and why?
The opportunity cost of cars is lower at home. This means that home has to sacrifice a
lower number of TVs to produce a car. Home has a comparative advantage in the
production of cars. The opportunity cost of TVs is 2/3 in foreign and 1.5 at home.
Foreign has a comparative advantage in the production of Tvs.
d. Using the information provided in problem 3 regarding Home, graph the world
relative supply curve.
Pc/Pt
1.5
2/3
1
Qc/Qt
When the relative price is below the opportunity cost of cars at home (2/3), both countries
are fully specialized in TVs as the wage in the TV industry is higher than the wage in the car industry.
The relative quantity of cars is zero.
When the relative price is equal to the opportunity cost of cars at home (2/3), workers in the
home country are indifferent between industries as the wage is the same. In Foreign, the wage in TVs
is higher than the wage in cars (the relative price is below the opportunity cost) and foreign will
specialize in the production of TVs. The relative supply curve is a horizontal line because home may
produce several combinations of cars and tvs.
When the relative price is between the two opportunity costs (>2/3 and <1.5), home will
specialize in cars (wage in cars is higher) and foreign will specialize in TVs. Home will dedicate all
resources to cars and produce 12 cars and foreign will dedicate all resources to TVs and produce 12
TVs. Between the two opportunity costs, the supply curve is a vertical line where relative supply is
equal to 1 (12/12). For all level of prices between 2/3 and 1.5, relative supply is equal to 1 (12/12)
because of full specialization of each country.
When the relative price is equal to 1.5 (opportunity cost in foreign), home remains fully
specialized in cars but the workers in foreign are indifferent between cars and tvs as the wage will be
equal across the two industries. The relative supply curve is a horizontal line.
If the relative price is higher than 1.5, both countries will produce cars and the production of
TVs will be zero.
4- Assume a classical world of two goods and two countries where labour is the only factor of
production. The amount of labour required per ton of output in the production of sugar and
coffee for countries A and B is given in the table below (for example 32 individuals are required
to work a day to produce 1 ton of Sugar in country A)
Sugar
Coffee
Country A
32
16
Country B
20
40
a. Calculate the opportunity cost of producing coffee in each country
When country A produces 1 ton of coffee it forgoes the production of half a ton of sugar, (½ ton of
sugar)
When country B produces 1 ton of coffee it forgoes the production of 2 tons of sugar
When country A produces 1 ton of sugar it forgoes the production of 2 tons of coffee
When country B produces 1 ton of sugar it forgoes the production of 1/2 tons of coffee
b. Explain the pattern of comparative advantage that exists.
Country A has a comparative advantage in the production of coffee; the opportunity cost of coffee in
terms of sugar is lower in country A than in country B
Country B has a comparative advantage in the production of sugar the opportunity cost of coffee in
terms of sugar is lower in country B than in country A
c. Suppose 40 individuals in B shift from producing coffee to producing sugar, and they
are able to sell that sugar at A’s domestic price ratio. How much more coffee would B
gain compared to the amount of coffee those 40 individuals initially produced in B?
With a complete specialization into sugar production country B produce 3 ton a day of sugar. For
every ton of sugar sold in A it is possible to buy 2 ton of coffee. Hence the 2 additional tons of sugar
produces in B could be sold against 4 tons of coffee and country B would gain 3 tons of coffee (4-1)