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ID: 1191447 • Letter: H
Question
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1) a. Refer to the figure above. Albania refused to engage in international trade for ideological reasons. To maximize its economic welfare it would choose to produce at which point in the diagram above?
b. The Cold War is over, and Albania is interested in obtaining economic welfare gains from trade. The international relative price is PA/PB = 2. Albania would therefore choose to produce at which point (a, b, or c)? (Hint: recall production decisions in standard trade model depend on the relative price.) Given this additional information, in which good does Albania enjoy a comparative advantage?
2) Refer to the figure above. Now, suppose that the relative price of A is actually not higher than Albania's autarkic level of PA/PB = 1, but PA/PB = 0.5. Would Albania still be able to gain from trade? If so, where would be its production point? Given the information in this question, where is Albania's comparative advantage?
Explanation / Answer
1.a.
The country should choose point “a” in the diagram to maximize its economic welfare.
Reason: At the point the concave budget line intersects with convex indifference curve. Budget line indicates financial ability and indifference curve indicates willingness. Therefore, the ability match with willingness at point “a” and economic welfare satisfies.
1.b.
Since PA/PB = 2, the price of good A is higher than good B. Therefore, producing good B is advantageous than good A. Good B should be produced more than good A.
The country should choose to produce at point “c” for obtaining gain.
The country enjoys a comparative advantage in good B, because its price/cost is lower than good A.
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