Econ111_S1_2012

Question 1. (5 marks) Using the same amount of resources, Australia and New Zealand can both produce apples and oranges as shown in the following table, measured in thousands of tonnes.

Australia New Zealand Apples Oranges Apples Oranges

12 0 6 0 3 3 3 3 0 4 0 6

i. Does either country have an absolute advantage in producing both goods? Explain your answer. Neither country has an absolute advantage in making both goods: Aust has the absolute advantage in producing apples (12 thousand apples). NZ has the absolute advantage in producing oranges (6 thousand oranges).

ii. Who has a comparative advantage in producing apples? Who has a comparative advantage in producing oranges? Explain your answer. Aust can produce 12 thousand apples (A) or 4 thousand oranges (R): 12A = 4R 1A = 1/3R (Austs OC of an apple is 1/3 orange) or 1R = 3A (Austs OC of an orange is 3 apples)

NZ can produce 6 thousand apples (A) or 6 thousand oranges (R): 6A = 6R 1A = 1R (NZs OC of an apple is one orange) or 1R = 1A (NZs OC of an orange is one apple)

Aust has the comparative advantage in producing apples (Austs opportunity cost of an apple is a third of an orange, less than NZs 1 orange). NZ has the comparative advantage in producing oranges (NZs opportunity cost of an orange is one apple, less than Austs 3 apples).

iii. Suppose that both countries are currently producing 3000 tonnes of apples and 3000 tonnes of oranges. Show that both can be better off if they specialize in producing one good and then engage in trade. Explain your answer, with the aid of diagrams. If both countries specialise in the good in which they have a comparative advantage and then trade with the other, they can both be better off. Specialisation: Aust should produce 12 thousand apples (A) Comparing OC: 1A = 1/3R Aust will accept any price above 1/3 orange for an apple. Acceptable price: 1A =

1R = 3A Aust will pay any price less than 3 apples for an orange. Acceptable price: 1R =

Acceptable ToT: 1A = 1/2R Trade: Aust exchanges 6A with 3R.

NZ should produce 6 thousand oranges (R) 1A = 1R NZ will pay any price less than 1 orange for an apple. 1/3R < any quantity of oranges < 1R 1R = 1A NZ will accept price above 1 apple for an orange. 1A < any quantity of apples < 3A 1R = 2A NZ exchanges 3R with 6A.

Econ111_S1_2012

Gains: Aust gains 3A (compared to their before trade production of 3A and 3R).

NZ gains 3A (compared to their before trade production of 3A and 3R).

The society as a whole gains a total of 6 thousand apples. Both countries are better off than before trading, since they end up with the same amount of oranges, but twice as many apples. Note that other trades (and terms of trade) will make them better off as well. The terms of trade (ToT) can fall within the range of the acceptable price of apples and oranges (see above), which means they are acceptable to both countries. An acceptable trade is shown below where the two trade lines meet (at 6000 apples and 3000 oranges) in Figure 1.

Figure 1 PPFs and Trade Lines for Aust and NZ

3,3 6,3

0

1

2

3

4

5

6

0 2 4 6 8 10 12 14

Oranges('000)

Apples('000)

Aust'sPPFNZ'sPPFAustTradeLineNZTradeLine