1. Assume that U.S. and China has same amount of resources in the production of Car and Computer. Following table described US and CHINA’s productivity.

USA / CHINA
CAR / 300 million / 200 million
COMPUTER / OR 900 million / OR 800 million

Who has absolute advantage in car?

USA because it produces more cars than China employing same resources

Who has absolute advantage in Computer?

USA because it produces more cars than China employing same resources

Who has comparative advantage in car?

Note the comparative advantage is the ability to produce at a lower O.C. To do this we need to compute opportunity cost of producing one car for USA and China.

O.C. of / In USA / In CHINA
1 CAR / 3 computer / 4 computer
1 COMPUTER / 1/3 car / ¼ car

Explanation: USA can decide to produce 300m cars or 900m computer. This means that opportunity cost of 300m car is 900m computer, which implies that O.C. of one car is 3 computers. Conversely, O.C. of one computer would be 1/3 of a car.

From the O.C. table it is clear the USA has comparative advantage in car since O.C of producing one car for the US is 3 computers, which is less than the O.C. for China (4 computers)

Who has comparative advantage in Computer?

China because ¼ is less than 1/3

  1. Draw US PPF below [label your graph appropriately].

car

Y

300 X

Z

900computer

  1. Draw China’s PPF below.

car

200 X

Z

Y

800 computer

  1. Who should specialize in what?

USA should specialize in car (because it has C.A. in car)

China should specialize in computer (because it has C.A. in computer)

  1. Fill up the table below:

USA / CHINA
Car / Computer / Car / Computer
Assume that before trade or specialization consumption bundle is given as / 200 / 300 / 100 / 400
Production when countries decide to specialize / 300 / 0 / 0 / 800
  1. Draw “Before trade or specialization consumption bundle” [that is 200,300 for USA and 100,400 for China] on the USA and China’s PPF in question b and c respectively. Call it point X

Shown in the US and Chinese PPC as point X

  1. Draw “Production when specialization takes place” on the USA and China’s PPF in question b and c respectively. Call it point Y

Shown in the US and Chinese PPC as point Y

  1. Come up with an exchange rate between Car and Computer that will make both country better off and fill up the table below assuming that USA wants to consume only 200 cars:

That means USA wants to trade 100 cars for computers from China.

By giving up 100 cars USA can easily produce 300 computers on its own. Therefore, USA will be better off if it can get more than 300 computers.

On the other hand, China’s O.C. for 100 cars is 400 computers. Therefore, China will be better off if it can get 100 cars by giving up less than 400 computers.

This suggests a mutually beneficial/acceptable exchange rate would be

100 cars = 350 computers

USA / CHINA
Car / Computer / Car / Computer
Before trade or specialization consumption bundle is given as / 200 / 300 / 100 / 400
Production when countries decide to specialize
(Just insert the same values as in e) / 300 / 0 / 0 / 800
After trade consumption bundle
(USA wants to consume 200 cars as she did before trade) / 200 / 350 / 100 / 450
  1. Draw “After trade consumption bundle” on the USA and China’s PPF in question b and c respectively. Call it point Z.

Shown in the US and Chinese PPC as point Z