20 The theory of comparative advantage

Chapter Twenty The theory of comparative advantage

Self-assessment Questions

20.1 Country Rich has an absolute advantage in producing bread because it is more productive in
bread than Country Poor, not because it is more productive in bread than machines.

20.2(a) Yes, Japan possesses an absolute advantage in all goods if it is more productive in all of
them.

20.2(b) No. It is impossible for a country to possess a comparative advantage in all the goods it
produces.

20.3 A country possesses a comparative advantage in a good over another country if its opportunity
cost of producing that good is lower.

The principle of comparative advantage states that if countries specialise in producing goods
in which they have the lower opportunity cost, their combined output will be maximised.

20.4 If the terms of trade is 1 machine for 1.6 bread, then

Country Rich’s gain from trade = (2 – 1.6) units of bread × 30

= 12 units of bread

Country Poor’s gain from trade = (1.6 – 1.11) units of bread × 30

= 14.7 units of bread

Multiple Choice Questions

1 B 2 C 3 A 4 A 5 D
6 C 7 D

2 From the table, we find that

For Hong Kong,

OC of 1 unit of garments = 0.33 unit of machines

OC of 1 unit of machines = 3 units of garments

For USA,

OC of 1 unit of garments = 0.5 unit of machines

OC of 1 unit of machines = 2 units of garments

This shows that Hong Kong has a comparative advantage in producing garments.

3 At the terms of trade of 2.5 units of garments for 1 unit of machines, Hong Kong will get back 12
units of machines from exporting 30 units of garments.

Its domestic opportunity cost of producing 30 units of garments is 10 units of machines.

Hence, its gain from exporting 30 units of garments is 2 units of machines.

New Introductory Economics 3rd Edition 45 © Pearson Education Asia Limited 2003
Suggested Solutions (2004 reprint with minor amendments)
 20 The theory of comparative advantage

4 From Q3, we know that its gain from exporting one unit of garments is 2/30 unit of machines =
0.067 unit of machines.

If the transport cost per unit of garments exceeds 0.067 units of machines, Hong Kong cannot
gain from trade, and hence will not trade with USA.

5 From the table, we find that the production possibilities of Country A and Country B are

Wheat Wool
Country A 600 400
OR
Country B 800 200

Country B possesses a comparative advantage in producing wheat because its opportunity cost of
wheat (0.25 unit of wool) is lower than that of Country B (0.67 unit of wool).

6 If Country A and Country B specialise completely according to the principle of comparative

advantage, their combined output will be 800 units of wheat and 400 units of wool, i.e. 100 units
more of each.

Short Question

8(a) Good Y, because it enjoys a comparative advantage in producing it.

8(b)(i) Country A’s gain from trade:

Domestic opportunity cost: 1X: 2Y
Terms of trade: 1X:1.5Y

By importing 10 units of X, Country A exports 15 units of Y. Its domestic opportunity cost

of producing 15 units of Y is 7.5 units of X. Hence, it gains 2.5 units of X.

8(b)(ii) By importing 10 units of X, Country A exports 15 units of Y. If it has to produce the 10

units of X herself, it has to sacrifice 20 units of Y. Therefore, it saves 5 units of Y.

Structured Essay Question

9(a) In Country A, the cost of producing 1 unit of machines is 0.67 unit of bread.

9(b)(i) Country A possesses an absolute advantage in producing bread because with one unit of
resources, it can produce more bread than Country B.

9(b)(ii) Country A has a comparative advantage in producing bread because its opportunity cost of
producing bread (1.5 units of machines) is lower than that of Country B (4 units of
machines).

9(c)(i) Country A will export bread. It gains because its export price exceeds its domestic
opportunity cost.

Its gain = (2 – 1.5) × 100 units of machines = 50 units of machines

New Introductory Economics 3rd Edition 46 © Pearson Education Asia Limited 2003
Suggested Solutions (2004 reprint with minor amendments)
 20 The theory of comparative advantage

9(c)(ii) Country B will export machines. It gains because its export price exceeds its domestic
opportunity cost.

Its gain = (0.5 – 0.25) × 60 units of bread = 15 units of bread

9(d) Two reasons are:

1) If transport cost is prohibitively high, countries may not engage in trade.

2) If insurance cost is prohibitively high due to high risks, countries may also choose not to
trade.

New Introductory Economics 3rd Edition 47 © Pearson Education Asia Limited 2003
Suggested Solutions (2004 reprint with minor amendments)