ECO101: David Ricardo’s Theory of International Trade - Concept of Comparative Advantage - 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 upwardsloping.

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.

Please Answer The Following Four True/False Discuss

1. Consider the following scenario:

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

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

The statement is FALSE.

David Ricardo’s theory of international trade is based on the concept of comparative advantage, not on the absolute advantage. A country enjoys a comparative advantage of producing one good if the opportunity cost of producing that good is less compare to the other country. According to theory of comparative advantage, a country will engage in trade with other country if it has the comparative advantage of producing any of the good.

In case of Australia ABC company

1 labor hr can produce

4 tons of steel per or 6 tons of sugar

4 tons of steel= 6 tons of Sugar

In order to produce 1 additional ton of steel, ABC company in Australia has to forego (6/4) =1.5 tons of sugar

Thus then opportunity cost for producing steel= 1.5 tons of sugar.

US Company XYZ

It can produce 2 tons of steel or 1 ton of sugar

2 tons of steel= 1 ton of sugar

1 ton of Steel= 1/2=0.5 ton of sugar

In order to produce 1 additional ton of steel, XYZ Company has to forego 0.5 tons of sugar.

The opportunity cost of producing steel is less in US XYZ Company among the two.

Hence according to Ricardo’s comparative advantage theory, XYZ Company will specialize in steel production and export steel.

On the other hand, the opportunity cost for producing sugar is less in ABC Company in Australia. They must specialize in sugar production and export sugar.

Both countries have 10 hours of labor available

Since US XYZ Company will specialize in steel production, 10 hrs of labor will produce 20 tons of steel in case of complete specialization.

On the other hand, ABC Company in Australia will specialize in sugar production and produce 60 tons of sugar in case of complete specialization.

When both of them open up for free trade, specialization will provide gain from trade for both the countries. The terms of trade must lie in between the opportunity cost ratio between the two countries. For example 1 ton steel = 1ton sugar can be considered as a feasible terms of trade that would provide benefit for both.

2. If we observe an increase in both price and quantity, the demand curve must be upward sloping.

The statement is FALSE.

The demand curve is not an upward sloping curve but it is a downward because of the law of demand. As the law of demand states, quantity demanded varies inversely with the price, other things remaining the same. We can explain the increase in both price and quantity with the help of fundamental demand supply model:

If there is an increase in demand, (may be due to increase in consumer’s income) the demand curve will shift to the right. In the above figure, the demand curve shifts from DD to DD’. In this case, both the equilibrium price and quantity will increase. Equilibrium price will rise from P to P’ and the equilibrium quantity will rise from Q to Q’. Hence an increase in both price and quantity can be explained with the rightward shift of the demand curve.

3. If the marginal product is falling average product must be falling.

The statement is FALSE.

Both the mathematical and graphical relation between MP and AP confirms that when MP curves is below the AP, then AP also declines.

Due to diminishing marginal returns, marginal product declines, But when it start declining, at the initial part, average product still continues to rise because the marginal product is still greater. MP equates AP when AP reaches to its maximum. But on the onset of diminishing marginal returns, the MP curve continues to decline and then comes below the average product curve. This only causes the average product curve to decline. The relation between the MP and AP is shown in the figure above.

4. If a firm is making zero profits it should leave the industry.

The statement is FALSE

If the firm is making zero profit, the firm should not leave the industry. Earning zero profit or normal profit implies the firm is operating at the break -even point where total revenue equals to total cost. The break -even point occurs at the minimum point of ATC curve. If the firm’s shuts down at the zero profit point, them it has to bear the full fixed cost, this is nothing but the loss for the firm. But if the firm continues operation, some of the fixed costs can be recovered and economic loss will also be less than the previous case. Thus it is better for the firms to continue the business operation even it reaches to break- even point. The firm must close the business or the shut down the business operations only when the price comes down below the minimum point of average variable cost. This is known as the shutdown point.