Managerial Economics

Assignment 2 (please submit answers in pdf format)

1. The following table describes the production possibilities of 2 cities.

Pairs of Red Socks per Pairs of White Socks per

worker per hour worker per hour
Bangalore 3 3
Coimbatore 2 1

a. Without trade what is the price of white socks (in terms of red socks) in Bangalore?
What is the price in Coimbatore?
b. Which city has an absolute advantage in the production of each colour sock? Which city
has a comparative advantage in the production of each colour sock?
c. If the cities trade with each other, which colour sock will each export?
d. What is the range of prices at which trade can occur?

(30 marks)
SOLUTION: -

A) Without trade what is the price of white socks (in terms of red socks) in Bangalore? What is
the price in Coimbatore?

Based on the chart, 3 pairs of white socks can be created in Bangalore by investing 1 worker-
hour (1 worker working for 1 hour). If the same amount of time were used to make the red socks,
then exactly 3 pairs of red socks would be made. A pair of white socks costs the same amount as
a pair of red socks - meaning that a pair of white socks costs the same amount as a pair of red
socks.

= In Bangalore 3 ÷ 3 = 1

It is estimated that one hour of labour with one worker in Coimbatore can produce two pairs of
red socks. If, instead of producing two pairs of red socks, one hour of labour with one worker is
utilized to produce exactly one pair of white socks, then exactly one pair will be produced.

So, a pair of white socks is equal to two pairs of red socks, or equivalently, a pair of white socks
is equal to two pairs of red socks. This is the price of white socks to red socks.
In Coimbatore = 1÷ 2 = ½

Socks are priced based on the opportunity cost of labour hours spent on their production.

B) Which city has an absolute advantage in the production of each color sock? Which city has
a comparative advantage in the production of each color sock?

There is a strong possibility that a city can have an upper hand in creating a product if it has
fewer resources than another country. The result is that this city has a better opportunity to
produce the same good. Since the cost of opportunity for a city is lower than that of another, they
have an edge when it comes to producing a certain good. As a result, they have a comparative
advantage and can produce a certain good more economically.

ABSOLUTE ADVANTAGE

In the production of both kinds of socks, BANGALORE has a clear advantage since a worker in
Bangalore produces more socks (3 pairs per hour) than a worker in Coimbatore (2 pairs of red
socks per hour or 1 pair of white socks per hour). In other words, Bangalore requires 1/3 of its
workers to produce 1 pair of red socks, while Coimbatore requires 1/2.

The production of a pair of red socks in Bangalore takes 1/3 Labour Hours, whereas a pair of
white socks in Coimbatore requires 1 Labour Hour (1/3 to 1), so Bangalore has a tremendous
advantage in this regard.

COMPARATIVE ADVANTAGE

Due to the opportunity cost of producing a pair of red socks in Coimbatore being half of a pair
of white socks, compared to the opportunity cost of producing a pair of red socks in Bangalore
being one pair of white socks, Coimbatore has a comparative advantage in producing red
socks.

As compared to Coimbatore, Bangalore has a comparative advantage in production of white

socks, since the opportunity cost of making white socks there is one pair of red socks, while the
opportunity cost for making white socks in Coimbatore is two pairs of red socks.

C) If the cities trade with each other, which colour sock will each export?

Cities that opened for trade would specialize in the kinds of products in which they have a
comparative advantage, and they would export those products.
The cities are likely to trade socks if Bangalore produces white socks for export, since white
socks are Bangalore's comparative advantage, while Coimbatore produces red socks for export,
since red socks are Coimbatore's, and vice versa.

D) What is the range of prices at which trade can occur?

• If the ratio between the domestic and export prices before a city opens up for trade is
higher than or equal to the ratio between the domestic and export prices, then it will
remain no worse off from trade.
• It is unlikely that mutually agreeable trade can occur if the terms of trade do not satisfy
this condition for either or both of a pair of cities, since the city where this does not hold
true will prefer not to trade since it will be better off without it.
• Bangalore, the exporter of white socks, will only accept a trade offer if the price of white
socks is greater or equal to the price of one pair of red socks. In the same way,
Coimbatore, the importer of white socks, will only accept an offer if the price of white
socks is less than or equal to two pairs of red socks.It is therefore possible to trade white
socks where the price of a pair of white socks is between the price of one pair of white
socks and the price of two pairs of red socks, ie, 1 pair red socks + price of one pair
white socks + 2 pairs red socks.