Explain how a mutually beneficial trade is possible in a two-country, two-commodity model even when one of the countries has absolute advantage in the production of both the commodities.
What will be an ideal response?
POSSIBLE RESPONSE: In a two-country, two-commodity model, even if one of the countries enjoys absolute advantage in the production of both the goods, a mutually beneficial trade is possible between them. In such a situation, the basis for beneficial trade between the countries is the difference in opportunity costs of producing the goods in each country. According to Ricardo, in this case, a country will produce and export the good that it can produce at a lower opportunity cost compared to the other country. On the other hand, a country will import the good for which it incurs a higher opportunity cost, compared to the other country.
The following example explains how a beneficial trade takes place between two countries on the basis of comparative advantage. Assume Country A and Country B produce Good X and Good Y. Country A requires two labor hours to produce one unit of Good X and one labor hour to produce one unit of Good Y. On the other hand, Country B requires 0.5 labor hours to produce one unit of Good X and 0.75 labor hours to produce one unit of Good Y. Thus, Country B has an absolute advantage in the production of both the goods. However, a mutually beneficial trade is still possible between the countries. The opportunity cost of producing Good X in Country A is two units of Good Y, but the opportunity cost of producing Good X in Country B is only 0.67 units of Good Y. Looked at the other way, the opportunity cost of producing Good Y in Country A is 0.5 units of Good X and that in Country B is 1.5 units of Good X. Therefore, we can see that Country A has a comparative advantage in producing Good Y and Country B has a comparative advantage in producing Good X. If, in the international market, one unit of Good X is exchanged for one unit of Good Y, both the countries can gain by exporting the good in which they have a comparative advantage and importing the other good. Country A will receive one unit of Good X in exchange for one unit of Good Y under free trade as compared to 0.5 units of Good X under autarky. On the other hand, Country B will receive one unit of Good Y in exchange for one unit of Good X, as compared to 0.67 units under autarky. Therefore, both countries gain when they enter into free trade with each other.
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