Let's Assume Only Two Countries Produce Two Goods M

Lets Assume There Are Only 2 Countries That Produce 2 Good Mor

Let’s assume there are only 2 countries that produce 2 goods. Specifically, the United States (US) and the United Kingdom (UK) each have 2 units of productive resources, with 1 unit allocated to the production of Wine and 1 unit allocated to Cloth. The US can produce 40 units of Wine and 40 units of Cloth per resource unit, while the UK can produce 20 units of Wine and 10 units of Cloth per resource unit.

Using this information, answer the questions below:

Analysis of Absolute and Comparative Advantage

To determine absolute advantage, compare the maximum outputs per resource. The US has an absolute advantage in both Wine and Cloth production since it can produce 40 units of each, compared to the UK’s 20 units of Wine and 10 units of Cloth.

For comparative advantage, compare the opportunity costs or relative prices:

• The relative price of Wine in the US is 40C/40W = 1C per W.
• The relative price of Cloth in the US is 40W/40C = 1W per C.
• The relative price of Wine in the UK is 10C/20W = 0.5C per W.
• The relative price of Cloth in the UK is 20W/10C = 2W per C.

Since the UK’s opportunity cost of producing Wine (0.5C per W) is lower than in the US, the UK has a comparative advantage in Wine production. Conversely, the US, with a lower opportunity cost in Cloth, should produce Cloth. Therefore, the US specializes in Cloth and the UK specializes in Wine.

Production Before and After Trade

Before trade, total production is based on each country using all resources for their respective comparative advantages:

• US produces 40 units of Cloth and 0 units of Wine.
• UK produces 20 units of Wine and 0 units of Cloth.

After trade, each country specializes:

• US specializes in Cloth, producing 40 units.
• UK specializes in Wine, producing 20 units.

Gains from Trade and Exchange Rates

The total increase in output is 10 additional units, reflecting gains from specialization and trade. The potential exchange rate range between the US and UK is determined by their opportunity costs:

• The US will trade Cloth for Wine at a rate better than 1 W/C (US’s opportunity cost), so more than 1 W per C.
• The UK will trade Wine for Cloth at a rate less than 2 W/C (UK’s opportunity cost for Cloth), so less than 2 W per C.

Therefore, the terms-of-trade will range between 1 W/C and 2 W/C, ensuring mutually beneficial exchange within this rate window.

Impact of a Tariff on Japan’s Car Market

In Japan, without a tariff, 10,000 cars are sold annually at $20,000 each. With a $5,000 tariff, supply decreases and quantity falls to 8,000, with the new price rising to $22,500 per vehicle. A supply and demand graph illustrating this scenario would show a parallel leftward shift of the supply curve by $5,000.

The increase in price is less than the full tariff because the burden is shared: consumers pay more ($22,500), and producers receive less ($17,500). The government’s tariff revenue equals $5,000 multiplied by 8,000 cars, totaling $40 million.

The deadweight loss, representing the loss of both consumer and producer surplus, can be calculated as follows:

• Deadweight loss = ½ × (quantity decrease) × (price difference) = ½ × (2,000) × ($2,500) = $2,500,000 in each surplus loss, totaling $5,000,000.

Negative Effects of Quotas and Subsidies

Graphically, quotas restrict the quantity of imports, artificially raising prices above equilibrium levels and creating inefficiencies. They tend to benefit domestic producers at the expense of consumers and can lead to a misallocation of resources.

Subsidies, on the other hand, provide financial support to domestic producers, encouraging higher production levels. While subsidies can promote domestic industry and employment, they often distort market signals, reduce efficiency, and lead to overproduction, which initially benefits producers but can harm consumers through higher prices and can strain government budgets.

Both quotas and subsidies create market distortions, reduce overall economic welfare, and can provoke retaliatory trade measures, thus negatively impacting international trade relations and economic efficiency.

References

• Krugman, P. R., Obstfeld, M., & Melitz, M. J. (2018). International Economics (11th ed.). Pearson.
• Melitz, M. J. (2003). The Impact of Trade on Intra-Industry Reallocations and Aggregate Industry Productivity. Econometrica, 71(6), 1695-1725.
• Crane, F. G. (2012). International Trade: Theory and Policy. Routledge.
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• Hill, C. W. L., & Hult, G. T. M. (2020). International Business: Competing in the Global Marketplace. McGraw-Hill Education.
• Ostry, J. D., Ghosh, A. R., & Spatafora, N. (2019). The Economics of International Trade. IMF Staff Discussion Notes.
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