ECO101: David Ricardo - US Company Produce 4 Tons of Steel per Hour, 6 Tons of Sugar - Microeconomics Assessment Answers

Please Answer The Following Four Ture/False Discuss

• Consider the following scenario:

Australia Company ABC can produce 4 tons of steel per labour hour or 6 tons of sugar. US Company XYZ can produce 2 and 1 respectively. Assume both countries have 10 hours of labour available.

ABC has an absolute advantage in steel, so should specialise in the production ofsteel. As David Ricardo stated both countries will benefit from trade.

2. If we observe an increase in both price and quantity, the demand curve must be upward sloping.
3. If the marginal product is falling average product must be falling.
4. If a firm is making zero profits it should leave the industry.

• False, In the question Australia has absolute advantage in the production of both steel and sugar as by ABC company in Australia can produce either 40 tons of steel or 60 tons of sugar with the 10 hours of labour available. XYZ Company in the US does not have absolute advantage in either steel or sugar as it can only produce 20 tons of steel and 10 tons of sugar with the 10 hours of labour available. When comparing sugar and steel Australian company ABC has absolute advantage in the production of sugar as it can produce more of sugar than steel with the given labour available. David Ricardo does not speak about absolute advantage and it was described by Adam Smith that the countries having absolute cost advantage in the production of a good will specialise in that good and and trade with other countries (Layton and Robinson, 2012). David Ricardo gave a theory of comparative cost advantage in which he describes that countries which do not have absolute advantage in the production of any good will specialise in commodities in which they have comparative advantage or least cost disadvantage and trade with other countries using this commodity. According to the comparative advantage theory related to this question we can say that Australia has absolute advantage in the production of sugar as it can produce 60 tons of sugar and the US Company XYZ as comparative advantage in the production of steel as it can produce 20 tons of steel with the given labour hours.
• False, If the prices and quantity of a commodity are both observed to be increasing, they can say that there is a shift in the demand curve rather than a upward sloping demand curve. Law of demand says that there is a inverse relationship between the price and the quantity demanded of the commodity (assuming other things to remain constant). This applies to all normal goods and services for which the demand increases when the price decreases. However there are certain commodities like the Veblen goods which have a status component in the demand for these commodities. Luxurious goods such as jewellery, diamonds, and cars are some of the examples of Veblen goods which are seen as the status symbol if these commodities are taken for higher prices. There are also other commodities like the Giffen goods which do not have close substitutes and in the fear of prices getting to be even higher, the quantity that is demanded also increases (Miller, 2012). In both these goods Veblen and Giffen goods, there are certain changes in the tastes and preferences of the consumers that are modified by the price changes of the commodity. This creates a shift in the demand curve and it does not indicate the upward sloping demand curve which is an impossibility.

• True, Marginal product and average product are concepts that are linked with the law of diminishing marginal returns. In this law there is only one variable input that is labour, which is increased to produce more output. The law of diminishing marginal returns is that the total product of a commodity initially increases at increasing rate which represents the stage one of production; then the total product of a commodity increases at a decreasing rate which is the stage of production for any firm; and lastly the total product of a commodity starts to decline with further increases in the variable input. Accordingly the marginal product and the average product increase initially; the marginal product reaches its maximum and then starts declining when the total product starts increasing at a decreasing rate; however average product is still increasing; but when marginal product cuts the average product the average product also starts declining but does not become negative; and total product starts declining marginal product becomes negative (William Baumol, 2012). Thus from the figure below we can see that when marginal product is falling the average product also is falling.

• When the firm in any industry is making 0 profits in the short run, it is not necessary for the firm to leave the industry and hence the answer to this question is false. In the short run the firm is either making supernormal profits or losses in perfectly competitive industry. Even in other industries whether it be imperfect competition or oligopolistic market, some firms may be able to cover only part of its fixed costs and might not be able to make profits in the short run. It is another for the firm to cover only its variable costs in the short run and some part of its fixed that costs of production (F.Samuelson and Marks, 2008). If the firm is able to cover all of its variable costs and some part of its fixed costs it need not leave the industry even though if it is making 0 profits or losses in the short run. The shutdown point of the firm is only when the firm is not able to cover even its variable costs of production in the short run; it’s makes it unviable to sustain in the long run. The following figure shows the shutdown point of a firm in an perfectly competitive market where the price of the commodity is shown by the horizontal line AR=MR

In the above figure, since the firm is able to cover its average variable costs of production, it need not shut down or leave the industry in the short run and continue to produce.