6/25/14

Comparative advantage and gains from trade example worksheet


The following shows an example problem asking you to construct a PPF (production possibilities frontier), calculate comparative advantage and find what potential gains from trade can be had. Answers are written in italics. Note that various versions of this sheet are given to students and they are then asked to conduct mutually beneficial trades.

1)    (do by yourself)  You are your own economy, you have a production possibilities set described below (the PPF in this case will be linear, so the tradeoff (opportunity cost) is ___________ as you produce more and more of a good).
Constant


Cell Phones
T-Shirts
0
100
400
0
blank graph


Your graph should be a straight line that intercepts the "cell phone" axis at 400, and the T-shirt axes at 100.

Sketch your PPF (production possibilities frontier) below, label the Y axis cell phones, and the X axis T-shirts:

Choose an arbitrary point on your PPF where you would like initial consumption to be.  In order for this consumption to be feasible, the point should be ____________ the PPF line.
On or inside (because outside is not feasible)

Calculate your opportunity cost for each good:

The opportunity cost of one cell phone is _______ T-shirts.
The opportunity cost of one T-shirt is ________ cell phones.
The opportunity cost for one cell phone is 1/4 of a T-shirt, and the opportunity cost of 1 T-shirt is 4 cell phones.

2)  (find a partner)  Figure out if you can trade with your partner so that BOTH of you are better off.  This will only occur if both of you have a ___________ advantage in a good, which means that the opportunity cost of both goods can’t be the ___________.
comparative/same

Who has the comparative advantage in t-shirts? Why?
whoever has the lower opportunity cost in t-shirts will have the comparative advantage.

Who has the comparative advantage in cell phones?  Why?
whoever has the lower opportunity cost in cell phones will have the comparative advantage

Who has the absolute advantage in t-shirts?  Why?
whoever has the capability of producing more t-shirts will have the absolute advantage

Who has the absolute advantage in cell phones?  Why?
whoever has the capability of producing more cell phones will have the absolute advantage

Now figure out a mutually beneficial terms of trade rate.  What is the lowest a mutually beneficial terms of trade can be?  Why?  What is the highest a mutually beneficial terms of trade can be? Why?  Answer these questions by stating how many t-shirts ONE cell phone is worth, ie. 1 cell phone for 5.5 t shirts.
The answer to this depends on the opportunity cost for each partner, for these example, the opportunity cost of 1 t-shirt is 4 cell phones, so you should be willing to accept any trade with a lower opportunity cost, in this example, giving up 3 cell phones for a t-shirt is a good deal because if you do not trade you would have to give up 4.

Given your terms of trade, trade a given amount with your partner so that both of you end up with more cell phones and t-shirts than in your initial consumption chosen in question 1).  Label this new consumption point on the graph.
After completing this question, you should have a point OUTSIDE of your PPF to show that while it is not possible to product outside of your PPF, it is in fact possible to consume outside of your PPF when engaging in mutually beneficial trade (and each party has a comparative advantage).


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