Absolute and Comparative advantage problems – practice set – August 2024

Question 1
Based on the given table, answer the following questions:

Number of labour hours required in the production of one Car

High Quality Car Low Quality Car
North 30 20
South 60 30

a. Which country has a comparative advantage for producing low-quality cars and which country
has comparative advantage in producing high-quality cars?
b. There are 1 million hours of labour available for making cars in the North, and another
1million hours of labour available for making cars in the South. In a no-trade world, let us
assume that two-thirds of the auto industry labour in each region is used to make high-quality
cars and one-third is used to make low-quality cars. What will be the global output of low-
quality cars and high-quality cars? (1 million= 10 lakh)
c. There are 1 million hours of labour available for making cars in the North, and another
1million hours of labour available for making cars in the South. Now, allow for specialization. If
each region completely specializes in the type of car in which it holds the comparative
advantage, what will be the global output of low-quality cars and high-quality cars?

Answer
First, compute no. of cars produced in one hour
High Quality Car Low Quality Car
North 1/30 1/20
South 1/60 1/30

a. If North produces 1/30 high quality cars in one hour, then it sacrifices production (opportunity
cost) of 1/20 low quality cars. Therefore, for 1 high quality car, it sacrifices 3/2 low quality cars.
For South, if it produces 1 high quality car, then it sacrifices 2 low quality cars.
Thus, North has comparative advantage in high quality cars.

Similarly, if North produces 1 low quality car, then it sacrifices production of 0.67 high quality
cars.
If south produces 1 low quality car, then it sacrifices production of 0.5 high quality cars.
Thus, South has comparative advantage in low quality cars.

b. 10 lakh labour hours are there.

2/3*10 lakh labour hours for high quality cars and 1/3*10 lakh for low quality cars.
For low quality car,
North = 1/3*10,00000*1/20= 16,666.67 and South = 1/3*10,00000*1/30=11,111.11
Thus total global production of low quality cars would be 27,777.78
For high quality car,
North = 2/3*10,00000*1/30 = 22,222.22 and South = 2/3*10,00000*1/60= 11,111.11
Thus total global production of high quality cars would be 33,333.33

c. In case of complete specialization, North would produce only high-quality cars and global
output would be 1000000*1/30 = 33,333.33.
South would produce only low-quality cars and global output would be 1000000*1/30 =
33,333.33 low quality cars.

Question 2
Kristen and Anna live in the beach town of Santa Monica. They own a small business in which
they make wristbands and pot holders and sell them to people on the beach. Kristen can make 15
wristbands per hour or 3 pot holders per hour. Anna is a bit slower and can make only 12
wristbands per hour or 2 pot holders per hour. Given the above information, answer the
following questions.
a. For Kristen and for Anna, what is the opportunity cost of a pot holder? Who has a comparative
advantage in the production of pot holders? Explain your answer.
b. Who has a comparative advantage in the production of wristbands? Explain your answer.
c. Assume that Kristen and Anna both work 20 hours per week in the business. If Kristen
devoted half of her time (10 out of 20 hours) to wristbands and half of her time to pot holders,
how many of each would she produce in a week? If Anna did the same, how many of each would
she produce? How many wristbands and pot holders would be produced in total?
d. Suppose that Kristen and Anna can sell all their wristbands for $1 each and all their pot
holders for $5.50 each. If each of them worked 20 hours per week, how should they split their
time between wristbands and pot holders? What is their maximum joint revenue?

Answer
a. Opportunity cost of 1 PH for Kristen = 15/3 WB = 5 WB
Opportunity cost of 1 PH for Anna = 12/2 WB = 6 WB
Hence, Kristen has comparative advantage in production of Pot holders.

b. Opportunity cost of 1 WB for Kristen = 3/15 PH = 0.2 PH

Opportunity cost of 1 WB for Anna = 2/12 PH = 0.16 PH
Hence, Anna has comparative advantage in production of Wrist bands.
c. Kristen: 10*15 = 150 WB ; 10*3 = 30 PH
Anna: 10*12 = 120 WB ; 10*2 = 20 PH
Total output: 270 WB and 50 PH

d. To maximise their joint revenue, Kristen and Anna should produce as per their comparative
advantage and go for complete specialization.
Kristen(who has comp adv in PH) : 20 hours * 3 = 60 PH
Anna (who has comp adv in WB): 20 hours* 12 = 240 WB
Kristen’s revenue = 60 PH * 5.5 $ = $ 330
Anna’s revenue = 240 WB* 1 $ = $240
Joint revenue = $ 570
( If for instance, Kristen wanted to produce PH based on comparative advantage, and Anna also
wanted to produce PH since price of a potholder is greater than price of a wrist band, then
Kristen’s revenue = 60 PH * 5.5 = $ 330
Anna’s revenue = 40 PH * 5.5 = $ 220
Joint revenue will be lesser = $ 550 )

Question 3
Consider the example of trade in two goods, shoes and refrigerators, between the United States
and Mexico. It takes four U.S. workers to produce 1,000 pairs of shoes, and it takes five Mexican
workers to do so. It takes one U.S. worker to produce 1,000 refrigerators, and it takes four
Mexican workers to do so.
Number of Workers needed Number of Workers needed
to produce 1,000 units — to produce 1,000 units —
Shoes Refrigerators
United States 4 workers 1 worker
Mexico 5 workers 4 workers

Which country is having absolute advantage in producing shoes? United States

Which country is having absolute advantage in producing refrigerators? United States
Which country is having comparative advantage in producing shoes? Mexico
Which country is having comparative advantage in producing refrigerators? United States

Bill-Colleen example from Case and Fair textbook

Wood (logs - daily production) Food (bushels - daily production)
Colleen 10 10
Bill 4 8
Colleen has absolute advantage over Bill in production of both commodities, food and wood.
Opportunity cost of 1W for Bill = 8/4 = 2F
Opportunity cost of 1 W for Colleen = 1F
Opportunity cost of 1F for Bill = 4/8 = 0.5W
Opportunity cost of 1 F for Colleen = 1W
Bill has comparative advantage in production of food.
Colleen has comparative advantage in production of wood.
If Colleen is selling one log of wood to Bill, the terms of trade will lie somewhere between
1bushel of F – 2 bushels of F. Colleen will not accept anything less than 1 bushel of food and
Bill will not be willing to pay anything more than 2 bushels of food.
Suppose Colleen and Bill both want equal numbers of logs and bushels of food. If Colleen goes
off on her own and splits her time equally, in one day she can produce 5 logs and 5 bushels of
food. Bill, to produce equal amounts of logs and food, will have to spend more time on the wood
than the food, given his productivity. By spending one third of his day producing food and two
thirds chopping wood, he can produce 2 2/3 units of each.
If both went for complete specialization based on comparative advantage, at the end of the day,
the two end up with 10 logs, all gathered by Colleen and 8 bushels of food, all produced by Bill.
By joining forces and specializing, the two have increased their total production of both goods.
United, they receive a bonus over what he or she could produce separately. This bonus—here the
2 1/3 extra logs of wood and 1/3 extra bushel of food—represent the gains from specialization.

Objective Questions – Answers

1. Overfishing arises as a result of ___________ property rights.
a. well-defined b. restricted c. ill-defined d. none of the options

2. Rohit can produce 20 cakes or 50 sandwiches in a day. Sanjana can produce 10 cakes
or 20 sandwiches in a day. Who has absolute advantage and comparative advantage in
production of cakes, respectively?
(a) Rohit, Sanjana (b) Sanjana, Rohit (c) Sanjana, Sanjana (d) Rohit, Rohit

3. A cardinal feature of the ______________ economy is that consumers determine what is

produced in the economy through their purchases. Laissez faire/free-market

4. Tax cuts, property rights, profits and wages are all examples of _______________.
incentives

5. Suppose Raj prefers to work for longer hours and earn a higher income. On the other hand,
Rahul prefers to work for fewer hours and earn lesser income, to spend more time with family.
As
economists, we don’t make judgments about their individual preferences. This is implicit in the
assumption of ________________ in the benchmark perfectly competitive market model.
Rational consumers