## 6/18/11

Now we have to determine who has the comparative advantage in each good. Luckily they both don’t have the same opportunity costs, otherwise there would be no potential for gains from trade. Lets look at papayas first:

US’s opportunity cost of a papaya is 3 apples.

Mexico’s opportunity cost of a papaya is ½ an apple.

So Mexico has the lower opportunity cost of producing a papaya so Mexico should specialize in papayas, and this leaves the US to specialize in apples. With both countries producing only what they have their comparative advantage in, the world economy now has more stuff.
A total of 63 apples and 24 papayas, where as before, with each producing some of both goods, we had a total of 51 apples and 15 papayas. So by specializing, we got more of both goods!

Now we have to determine what the possible grains from trade are. In order to do this we have to have some initial production values for the goods. For this example, I will assume that the US was producing 42 apples, and 7 papayas, and that Mexico was producing 9 apples, and 8 papayas. When we add these numbers together, we get a total of 51 apples, and 15 papayas (the numbers that were mentioned earlier).

Now after specialization, we see that there are a total of 63 apples and 24 papayas in the economy. At this point what you do is arbitrary, but I think the first goal should be to allow the countries to consume what they were originally producing.

In this case the US would get 42 apples and 7 papayas, and Mexico would get 9 apples and 8 papayas. This leaves 12 apples and 9 papayas as the gain from trade. We can divide each by two and split them between the countries, this means that the US now gets 48 apples, and 11 papayas, and Mexico gets 15 apples, and 13 papayas. So both countries are better off and get more of both goods when they specialize and trade! They are also consuming outside of their PPF! So by allowing for trade, countries can consume more than if they were closed to trade (but in order for this result to hold, each country MUST have a comparative advantage in a good). The table below shows this breakdown:

Remember that starting and ending amounts are arbitrary, at this time in the semester we don’t know if the Mexico even likes apples, so these amounts will be given to you by the book or the problem. What you really need to know are the steps below:

1. Determine the opportunity costs of production.
2. Figure out who has the comparative advantage.
3. Have each country specialize in their comparative advantage.
4. Figure out an allocation that makes each country better off.