Answer Key 1 Comparative Advantage

Answer Key 1 Comparative Advantage Econ 101 Professor Guse Al and Carl both like to consume wine and bread and both are capable of producing wine and bread. Carl can make up to 60 loaves of bread per month. For each bottle of wine he makes his bread ouput drops by a 1 2 loaf. Al can make up to 20 bottles of wine per month. For each loaf of bread he bakes his wine output decreases by a 1 2 bottle. 1. Draw Al s monthly production possibility frontier - the set of output combinations he his capable of producing. 2. Suppose Al is currently producing and consuming on his PPF making 10 bottles of wine per month. (a) Mark this point in your picture of Al s PPF. ANSWER: See figure 1. (b) How many loaves of bread does Al bake each month? ANSWER: 20 loaves. See figure 1. (c) What is Al s opportunity cost of increasing his wine output by 1 bottle to 11 / month? ANSWER: 2 loaves for each extra bottle of wine he makes. This is because Al s PPF has a slope of 2 loaves per bottle everywhere. (d) What is Al s opportunity cost of increasing his bread output by 1 loaf per month? ANSWER: The inverse of the previous answer - 1 2 bootle of wine per loaf. 3. Draw Carl s monthly production possibility frontier - the set of output combinations he his capable of producing. 4. Suppose Carl is currently producing and consuming on his PPF making 20 bottles of wine per month. (a) Mark this point in your picture of Carl s PPF. ANSWER: See figure 1. (b) How many loaves of bread does Carl bake each month? ANSWER: 50 Loaves. See figure 1. (c) What is Carl s opportunity cost of increasing his wine output by 1 bottle per month? ANSWER: 1 2 loaf for each extra bottle he makes. This is because Carl s PPF has a slope of 1 2 loaf per bottle everywhere. (d) What is Carl s opportunity cost of increasing his bread output by 1 loaf per month? ANSWER: The inverse of the previous answer - 2 bootles of wine per loaf. 1

60 Carl s No Trade Point 50 40 Bread (loaves) 20 AL s No-Trade Point AL s PPF CARLs PPF 10 20 40 60 80 100 120 Wine (bottles) Figure 1: Without trading, both players are producing and consuming on their individual PPFs. Table 1: Production, Trade and Consumption Plan for Al and Carl. Original Original Output New Trade Final Output Consumption Change Output Gain Consumption Al Wine 10 10-10 0 +15 15 Al Bread 20 20 +20 40-15 25 Carl Wine 20 20 +20 40-15 25 Carl Bread 50 50-10 40 +15 55 5. Draw Al and Carl s combined PPF and mark the current production and consumption point. ANSWER: See Figure 2. 6. Propose and production and distribution scheme in which both Al and Carl are still producing on their individual PPF and can each increase their consumption of both goods by one unit. Mark this point in your combined PPF diagram. ANSWER:. Figure 2 illustrates how total output can grow in both goods. As we see in the diagram, one possibility is to have Al give up wine-making and make 40 loaves of bread while having Carl produce 20 more bottles of wine and 10 fewer loaves of bread. As seen in the diagram, these changes lead to higher output of both good - 10 more bottles of wine and 10 more loaves of bread. Table 1 shows one production and trade or distribution plan that splits the gain in output of each good evenly achieving 5 more units of both for both agents. Many possibilities here. 7. Answer question 1 in Test Yourself Questions at the end of Chapter 3 in the Baumol and Blinder Text: A person rents a house for which she pays the landlord $12,000 per year. 2

Al s Original Output 100 Al s New Output after specialization. 80 70 NO TRADE Al completely Specializes Vector of Al s Change in Output Carl s Change in Output 60 50 Carl s No Trade Point Combined PPF 40 Bread (loaves) 20 AL s No-Trade Point AL s PPF CARLs PPF 10 20 30 40 50 120 140 Wine (bottles) Figure 2: By specializing in their respective comparative advantage production activities, total output in both goods can be increased. In this example, Al completely specialized in Bread production moving along his individual PPF from (10,20) (in green) to (0,40) (in red). Meanwhile, Carl specialized in wine (though not completely so) producing twenty more bottles of wine and 10 fewer loaves of bread. This change is represented by a movement along his individual PPF (highlighted in blue). Due to specialization Al and Carl can increase their combined output of both goods moving from (30,70) to (40,80). 3

Own Rent Lost Interest $4000 $ 0 Taxes & Maintenence $ X $0 Rent $ 0 $12000 Total $ (4000 + X) $12000 Table 2: Cost of renting versus homeownership. The house can be purchases for $100,000, and the tenant has this much money in a bank account earning 4% interest. Should she buy? Explain using opportunity cost. ANSWER: Assume that the house will always be worth $100,000 (no appreciation and no depreciation) and that annual property taxes and maintenance on the house add up to X. Assume also that rent is collected at the end of the lease. (This won t make too much of a difference.) Now consider renting. This would entail keeping the $100,000 in the bank, earning $4,000 in interest and paying $12,000 in rent. At the end of the year the renter would have total assets of $92,000. Next consider buying. In this case the $100,000 is spent to purchase the house, no rent is paid, and the owner-resident is responsible for taxes and maintenance of X. At the end of the year, the owner s total assets are $100,000 - X. Hence as long as the annual out-of-pocket expenses (property taxes and maintenance) do not exceed $8,000, it is worth buying. The opportunity cost of buying consists on the property taxes, maintenance expenses AND lost interest ($4,000). The opportunity cost of renting is the lost rent ($12,000). 8. This question is adapted from Jeffrey Perloff s text Microeconomics. Two countries, the U.S. and France, can produce food and handbags. France has 100 workers and the U.S. has 300 workers. The following table shows the labor requirements for each good in each country. France U.S. Workers per ton of food 10 10 Workers per handbag 50 20 (a) Draw the individual PPF for each country. Identify comparative advantages. AN- SWER. See Figure 3. To make a ton of food the U.S. needs 10 workers. Pulling those 10 worker out of handbag production would cost 1 2 handbag (since it take 20 workers to make 1 whoel handbag). Meanwhile in France it also take 10 worker to make 1 ton of food. However, in France pulling those 10 workers out of handbag production would only cost 1 5 handbag. Therefore France has the comparative advantage in food (while the U.S. has the c.a. in handbags). 4

Table 3: Production and Consumption Plan for France and U.S Original Original New New Labor Final Output Labor Force Output Force Consumption France Food 5 50 10 100 5.5 France Handbags 1 50 0 0 1.5 U.S. Food 10 100 6 60 10.5 U.S. Handbag 10 200 12 240 10.5 (b) Suppose that in the absence of trade (autarky), the U.S. produces and consumes 10 tons of food while France produces and consumes 5 tons of food. Assuming full employment, what is the handbag output in each country? Mark the appropriate point on each country s PPF and describe how many workers in each country are employed in each industry. ANSWER See Figure 3 and the original labor force column in Table 3. (c) Draw the combined PPF and show that both countries can benefit from trade by proposing an outcome in which both countries end up consuming more food and more handbags. ANSWER. In Figure 3 the red points represent the original production and consumption points. The green points represent one possible production plan that allow an increase in the two countries output of both goods. In the green-dot example, the U.S. reduces food output by 4 tons and increasing handbag output by 2 while France increases food output by 5 tons and reduces handbag output by 1. (d) How many workers in the U.S. have to be retrained? ANSWER. To achieve the handbag output increase of 2 handbags in the U.S., 40 workers get transfered from the farms to the factories resulting in the 4 tons reduction in food ouput we see in the diagram and no doubt causing some disruption and requiring retraining. 5

17 Handbags 15 12 U.S. Output after Spec n Post Specialization 11 10 US Output No Trade No Trade Combined PPF 2 1 French PPF French Output No Trade 5 French Output after Specialization 10 15 16 U.S PPF 30 Food 40 Figure 3: Individual and Combined PPFs for the U.S. and France in Food and Handbags. 6