Explain the differences between the two-country, two-commodity model with constant costs of production and the two-country, two-commodity model with increasing costs of production. Adequately describe the production-possibilities curves for each country in each case. Describe free-trade production and the degree of specialization in each country under both cost situations.

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE: If the cost of production of each good is constant, the opportunity cost of production of one good (in terms of production foregone of the other good) is also constant. In an economy with constant cost of production, the production-possibility curve (PPC) is a straight line. With free-trade and constant-production costs, it is beneficial for a country to fully specialize in the production of one good and export this good in exchange for imports of the other good. The good that will be produced is the good with an opportunity cost that is lower than the relative international price of this good (the price of the good expressed in units of the other good). Conversely, the good with an opportunity cost higher than the international price will be imported. The result is complete specialization. This is based on Ricardo's idea of comparative advantage and complete specialization. Ricardo assumed that all goods are produced with one factor of production-labor-and to double the production of a product, a producer just needs to double the amount of the input factor-the labor hours. Realistically, however, production requires a variety of factor inputs: land, skilled labor, unskilled labor, capital, etc., and different products use factor inputs in different proportions. The difference in factor proportions leads to an increasing cost of production. That means the production-possibilities curve is bowed-out. In other words, the opportunity cost of production of one good is not constant but rather increasing with increased production of this good. Under such a situation, when a country engages in free trade, it will usually produce both goods (incomplete specialization). Still, it will export that good which it can produce at a relatively lower cost and import the other good.