Trade & Cost Worksheet 2

Ecns 201

Suppose we have two countries, Grandia and Vastland and each has capabilities to make two dietary staples consumed by the population: Beer and Wine. The following table gives the production possibilities:

Country /

Beer

Wine

Grandia

/ 120 Kegs OR 40 Barrels

Vastland

/ 100 Kegs OR 20 Barrels

Marginal Costs are:

Country /

Beer

Wine

Grandia

/ 1/3 barrel of wine / 3 kegs of beer

Vastland

/ 1/5 barrel of wine / 5 kegs of beer

Initially, the two countries are isolated from each other and there is no opportunity for them to make cooperative arrangements or to trade. Therefore, they must produce whatever they consume. This is known as a state of “Autarky” and for each country, consumption = production within that country. We could say that the countries are “self sufficient.”

Production responds to consumption desires and most people want a mixture of goods rather than one or the other. That phenomenon is called “generalization in consumption.” There is no special formula to determine the exact mixture of beer and wine that people in each country will want to consume, but given “efficient production” in each country and generalized consumption, the following would be possible:

Autarky Production and Consumption: (you fill in the blanks)

Country /

Beer

Wine

Grandia

/ 54 Kegs

Vastland

/ 35 Kegs

TOTALS

/ 89 Kegs

Now, suppose that the two countries establish cooperative relations with each other and agree to open free trade between them. This will allow each country to specialize in the production to what they do best. Suppose that each country COMPLETELY specializes in its comparative advantage good. Production will be:

Country /

Beer

Wine

Grandia

Vastland

TOTALS

Notice that the TOTAL amount produced or each good exceeds the totals when each country was operating autonomously (in autarky).

But each country does NOT want to specialize in consuming only what it produces, so there will have to be trade.

Trade can take place according to “terms of trade” that are between the two countries’ Marginal Costs of Production. Thus if the trading price of 1 barrel of wine is 4 kegs of beer, that will benefit BOTH Grandia, which can make the wine for 3 kegs of beer, and Vastland, which would have to give up 5 kegs of beer to make their own wine.

Suppose that the 4:1 trading ratio is adopted. The Terms of Trade are 4 kegs of beer for 1 barrel of wine. Further suppose that the countries agree to trade 60 kegs of beer for 15 barrels of wine. The beer and wine then available for consumption in each country is shown in the following table:

Country /

Beer

Wine

Grandia

Vastland

TOTALS

Compare this to the Autarky (no specialization and trade) amounts that are available to the citizens of each country.

Not-so-subtle additional observations:

Before specialization and trade, people in each country invested in wine making and beer brewing. Are those people all made better off with specialization and trade?

Country /

Beer Investors

Wine Investors

Grandia

Vastland

How do consumers fare with specialization and trade if they drink only wince or beer?

Country /

Beer Drinkers

Wine Drinkers

Grandia

Vastland