Consider the following two country-two goods world, with a single input, labor:
Daily production per worker
Commodity Portugal England
Wine (barrels) 2 OR 1
Cloth (bolts) 4 OR 3
a) Does either country have absolute and/or comparative advantage in any product? Provide support for your answer by computing the "resource costs" or opportunity costs for both products in both countries.
b) Following your answer to part a, is there any advantage in trading here? At what "prices" will such trade occur? In other words, what is the maximum amount of cloth relative to wine at which trade will occur? What is the minimum amount?
c) Suppose the total cost of labor to produce daily output in each country is £20 in England, and E1600 (escudos) in Portugal. Further, let the exchange rate is £1=E50, what is the price of the goods in each country in pounds?
d) What will the exchange rate have to be to discourage Portuguese imports of British goods? Similarly, what will the exchange rate have to be to discourage British imports of Portuguese goods?
A country has an absolute advantage economically over another, in a particular good, when it can produce that good more efficiently than the other. In this case we can clearly see that with the same amount of labor, Portugal can produce more wine and more cloth. It has absolute advantage in both areas.
What matters for comparative advantage is not the absolute cost of production but the opportunity cost. The opportunity cost is calculated by dividing the amount of one good by the amount of another good that can be produced with the same amount of resources. So we have:
The cost of wine in Portugal is only two bolts of cloth, while in ...