Reference no: EM131634788

Question: Comparative advantage and trade:

(a) In Elbonia, one unit of labor can produce either 5 bottles of beer or 5 bags of chips. It must be the case that 1 bottle of beer trades for 1 bag of chips, so the price of beer is 1. Why? If the price were different, the economy would want to produce only beer or only chips. (For example, suppose 1 bottle of beer sold for 2 bags of chips. Then one unit of labor could produce 5 bottles of beer, which could be traded for 10 bags of chips. This would be better than producing chips directly, except for the fact that it means that no one would be producing chips! So this can't be an equilibrium.) But since consumers insist on enjoying both goods, both must be produced, so the price must be 1 in Elbonia. This same logic lets you calculate the price in the other economies. The price of beer in Genovia must be 2 bags of chips.

(b) When the economies are closed, beer sells for 1 bag of chips in Elbonia but 2 bags in Genovia. Beer is expensive in Genovia, and chips are expensive in Elbonia. This means that Genovia has a comparative advantage in chips and will export chips. Elbonia has a comparative advantage in beer and will export beer. Using the prices in the closed economy, you should be able to determine the pattern of trade in a similar fashion for the other country pairs.