Quiz 1
Answer key
Holland and Belgium produce Cheese and Beer using only labor as the factor of production.
Labor is immobile between the two countries but mobile within each country.
Holland Belgium
Labor required to make 1 cheese 50
Labor required to make 1 beer 5
90
6 a. Calculate the opportunity costs of 1 cheese in terms of beers and the opportunity cost of 1 beer in terms of cheese for each country. Based on these computations, determine the comparative advantage for each country.
From the labor requirements, opportunity cost can be calculated:
Holland Belgium
Opportunity cost of producing 1 cheese 50/5 = 10 beers 90/6 = 15 beers
Opportunity cost of producing 1 beer 1/10 of a cheese 1/15 of a cheese
When Holland produces 1 cheese, it could have produced 10 beers instead. Those 10 foregone beers are
Holland’s opportunity cost of producing 1 cheese. Note that the opportunity cost (in terms of beers) of producing 1 cheese can be calculated by dividing the labor required to make 1 cheese by the labor required to make 1 beer. If the 50 units of labor required to make 1 cheese were instead allocated to beer production, then those 50 units of labor would produce 10 beers.
Each country has a comparative advantage in the good that it can produce at a lower opportunity cost than the other country, by definition. Note that if a country has a comparative advantage in some good, this does not necessarily mean that the country can produce this good more cheaply in terms of the input
(in this exercise, labor) than the other country. For example, Belgium has a comparative advantage in making beer even though it requires more labor to produce a beer than Holland (i.e. even though Holland has an absolute advantage in making beer). b. Suppose that each country has 900 units of labor. Draw the PPF for both Holland and Belgium with cheese on the horizontal axis and beer on the vertical axis. Suppose that without trade
Holland produces and consumes 10 units of cheese and 80 units of beer and Belgium consumes and produces 6 units of cheese and 60 units of beer. Mark these points on your diagram.

Note that 900/5=180; 900/50=18; 900/6=150; 900/90=10. These are the endpoints of the PPFs because they are quantities of a good that a country can produce if it uses all of its labor to produce that good, that is if it specializes completely in producing that good. c. Now suppose that each country specializes in the good in which it has a comparative advantage, so that Holland produces 18 cheeses and Belgium produces 150 beers.
They agree on a price between their opportunity costs (more than 10 beers per cheese, less than
15 beers per cheese), and trade goods at that price. Suppose a price of 12 beers per cheese.
Suppose that Holland trades 7 of its 18 cheeses for 84 of Belgium’s 150 beers. What are Holland and Belgium production and consumption of cheese and beers? What are the gains from trade?
With trade, Holland has 11 cheeses and 84 beers, and Belgium has 7 cheeses and 66 beers.
They consume at points B and D, which would not be possible without trading (i.e. these points are beyond the PPFs). Note that joint production under autarky (which means “no trade”) was
140 beers and 16 cheeses, but under trade is 150 beers and 18 cheeses. By specializing and trading, both countries can consume more of both goods, and thus are both better off than under autarky.
Gains from trade: 10 beer and 2 cheese .