Opportunity Cost, Production Possibility, and Trade: Exam Questions

Question 1

Suppose an hour’s labour produces 10 kg of rice and 5 meter of cloth in India, and 5 kg and 2 meter in Thailand. Using opportunity costs, explain which country will export cloth and which will export rice in trade? (10 marks)

Question 2

Suppose Mike and Johnson produce two products-hamburgers and T-shirts. Mike produces 10 hamburgers or 3 T-shirts a day and Johnson produces 7 hamburgers or 4 T-shirts. Assuming they can devote time in making either hamburgers or T-shirts

a.    Draw the production possibility curve (2.5 marks)

b.    Who enjoys the absolute advantage of producing both? (2.5 marks)

c.    Who has higher opportunity cost of making T-shirts? (2.5 marks)

d.    Who has a comparative advantage in producing hamburgers? (2.5 marks)

Question 3

Consider two countries (Home and Foreign) that produce goods 1 (with labour and capital) and 2 (with labour and land) according to the production functions listed below (Table 1 and Table 2). Initially, both countries have the same supply of labour (100 units each), capital, and land. The capital stock in Home then grows. This change shifts out both the production curve for good 1 as a function of labour employed (Table 1) and the associated marginal product of labour curve (Table 2). Nothing happens to the production and marginal curves for good 2.

a.    Show how the increase in the supply of capital for Home affects its production possibility frontier. (2.5 Marks)

b.    On the same graph, draw the relative supply curve for both the Home and the Foreign economy. (2.5 marks)

c.    If those two economies open up to trade, what will be the pattern of trade (i.e., which country exports which good)? (2.5 Marks)

d.    Describe how opening up to trade affects all free factors (labour, capital, land) in both countries. (2.5 marks)

Question 1

Answer 1.

    Producing rice’s opportunity cost in India is (5/10) = 0.5.

    Producing cloth’s opportunity cost in India is (10/5) = 2.

    Producing rice’s opportunity cost in Thailand is (2/5) = 0.4.

    Producing cloth’s opportunity cost in Thailand is (5/2) = 2.5.

 Therefore, producing rice has less opportunity cost in Thailand than India, whereas, producing cloth has less opportunity cost in India. Hence, India will produce and export cloth as the opportunity cost of production of cloth is less in India than in Thailand. If India produces rice, then the country will sacrifice a great deal on the opportunity cost of rice. Similarly, following the views given by Costinot and Vogel (2015), it can be stated that Thailand will produce and export rice. It will ensure the country losing less as producing cloth in the country will cost extra in the terms of opportunity cost of producing cloth.


Answer 2.

As shown in the figure above, the maximum possible number of hamburgers is 17, that can be produce with given recourses (Feenstra 2015). If both Mike and Johnson produces hamburgers and do not allocate any resource to the production of T-shirts, then achiving this number will be possible. Similarly, the maximum number of T-shirts that can be produced by Mike and Johnson is 7.

(b)    Mike makes more hamburgers than Johnson does, whereas Johnson makes more T-shirts than Mike at the same time. Therefore, no one enjoys the absolute advantage of producing both (Deardorff 2014).

(c)    Mike’s opportunity cost of producing T-shirts is (10/3) = 3.33.

    Johnson’s opportunity cost of producing T-shirts is (7/4) = 1.75.

    Therefore, Mike has higher opportunity cost of making T-shirts.

(d)    Mike’s opportunity cost of producing hamburgers is (3/10) = 0.3.

    Johnson’s opportunity cost of producing hamburgers is (4/7) = 0.57.

    Therefore, Mike has comparative advantage in producing hamburgers.

Answer 3.

As shown in the figure above, the increase in the supply of capital for Home pushes the production possibility frontier outwards. However, it will only increase for good one as nothing happens to the production and marginal curves for good 2. This will make the Production Possibility Frontier shift partially towards good 1’s side (Thirlwall, Rampa and Stella 2015).

As shown in the figure above, the relative supply curve for both the countries will be like a step diagram. It will start from the point where the home country produces good 1. Then the amount of good 2 by foreign country will appear in the curve. After that, the home country’s increased supply amount will be added. It will again increase the curve vertically (Thirlwall 2014). The red portion is home country’s supply and blue portion is foreign country’s supply curve.