Consider two countries, Shirtland and Chipland, both of which are capable of producing shirts and computer chips. Shirtland can produce the following combinations of shirts and chips. All shirts and no chips: 108 shirts per day.
All chips and no shirts: 36 chips per day.
Chipland can produce the following combination of shirts and chips.
All shirts and no chips: 120 shirts per day.
All chips and no shirts: 120 chips per day.
In each country, there is a fixed trade-off of shirts and chips.
a) Draw the two production possibilities curves (these are straight lines), with shirts on the vertical axis and chips on the horizontal axis.
b) Which country has absolute advantage in the production of shirts? Which one has absolute advantage in the production of chips?
c) Suppose that each country is initially self-sufficient and each country divides its resources equally between the two goods. How much does each country produce and consume?
d) Which nation has comparative advantage in shirts? Which one has comparative advantage in chips?
e) Suppose each country decides to specialize in the production of only one good, which good should they produce? Suppose they decide to exchange 2 shirts per chip, and Chipland trade 40 chips, how much of each product does each country now consume? Are there any benefits from specialization and trade? Explain.
f) Suppose instead of exchanging 2 shirts per chip, Chipland instead wants 4 shirts for every chip traded. What effect will this have on trade?