Suppose that real GDP includes just cars and computers. The United States produces 50 cars and 5 computers, while Japan produces 5 cars and 10 computers, and each country has 10 workers and customers who demand both products. The two countries then decide to specialize in the production of just one good based on their comparative advantage and buy the other good from the other country is producing through trade. In the marketplace, the exchange ratio of cars for computers is 1 computer = 1 computer. Please draw the production possibility set and mark the combinations of cars and computers at both the initial (pre-trade) equilibrium and the post-trade equilibrium in each country. What to each country’s GDP? Can you compute and show graphically the gains from trade for each country?

In the diagram below, we have shown production possibility frontier for both the countries. Here, US is producing 50 computers and 5 cars (point A) whereas, Japan is producing 5 computers and 10 cars (point B).

[Find the figure in attachment 1]

Now, opportunity cost of producing computers in US = 10/100 = 0.1 and opportunity cost of producing cars in US = 100/10 = 10.

Similarly, opportunity cost of producing computers in Japan = 20/10 = 2 and opportunity cost of producing cars in US = 10/20 = 0.5.

As opportunity cost of producing computers is lower for US, US has comparative advantage in the production of computers.

As opportunity cost of producing cars is lower for Japan, Japan has comparative advantage in the production of cars.

Under specialization, US will produce 100 computers only whereas, Japan will produce 20 cars only.

Now, with trade, if US consumes 50 computers, it can export remaining 50 computers to US, for which it gets 50 cars in return (exchange rate being 1 computer = 1 car). Thus, US gains 50-5 = 45 cars from trade. The new consumption point is C with trade.

Similarly, with trade, if Japan consumes 10 cars, it can export remaining 10 computers to US, for which it gets 10 computers in return (exchange rate being 1 computer = 1 car). Thus, Japan gains 10-5 = 5 computers from trade. The new consumption point is D with trade.

We have shown the gains from trade in the diagram below:

[ Find the figure in attachment 2 ]

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