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NSS Exploring Economics 6

Chapter 11

International trade (I) free trade and principle of comparative advantage

Questions
p.124
Think it over
The photos show some of the imported goods we consume. Why does Hong Kong import
them rather than produce them domestically?
p.126
Discuss
11.1
If Country A has a higher productivity than Country B in the production of all goods, should
Country A produce all the goods itself? Should Country B produce nothing?
11.2
Country A has an absolute advantage in the production of all goods. Does Country A also
have a comparative advantage in the production of all goods?
p.127
Discuss
11.3
What determines international specialisation and trade? Absolute advantage or comparative
advantage?
p.130
Test yourself
11.1
Use the above example about Country A and Country B to illustrate that absolute advantage
and comparative advantage are unrelated.

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Questions and Answers to Exercises (Chapter 11)

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p.132
Test yourself
11.2
Refer to Section 11.3 above. What is the terms of trade of 1C? What are the gains of two
countries from trade? Show your answers by completing Fig. 11.3.

Discuss
11.4
Refer to Table 11.2. Will Country A and Country B trade food with each other under the
following situations?
a. The terms of trade is 1F to 0.5C.
b. The terms of trade is 1F to 0.8C.
c. The terms of trade is 1F to 2.5C.

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Questions and Answers to Exercises (Chapter 11)

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pp. 143-146
Exercises
Multiple Choice Questions
1.
Which of the following descriptions about absolute advantage and comparative advantage
is INCORRECT?
A. A country has an absolute advantage over another country in producing a good if it can
produce a larger amount of the good than the other country with the same amount of
resources.
B. A country has an absolute disadvantage over another country in producing a good if it
has a lower productivity in the production of the good than the other country.
C. A country has a comparative advantage over another country in producing a good if it
can forgo a smaller amount of another good than the other country in producing the
same amount of the good.
D. A country has a comparative disadvantage over another country in the production of a
good if it can produce the good at a lower opportunity cost than the other country.
2*.
Suppose Country A and Country B produce Good X and Good Y only. If Country A has a
comparative advantage in producing Good X over Country B,
A. Country A produces a larger amount of Good X than Country B with the same amount of
resources.
B. Country A produces Good X at a lower opportunity cost than Good Y.
C. Country A produces Good Y at a higher opportunity cost than Country B.
D. Country A also has an absolute disadvantage in producing Good Y over Country B.
3.
The following table shows the output of Good X and Good Y per unit of resources in Country
A and Country B.
Good X (units)
Good Y (units)

Country A

Country B

8
2

10
6

Which of the following descriptions is correct?


A. Country A has an absolute advantage in producing Good X.
B. Country B has an absolute disadvantage in producing Good Y.
C. Country A has a comparative disadvantage in producing Good X.
D. Country B has a comparative advantage in producing Good Y.

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Questions and Answers to Exercises (Chapter 11)

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4*.
The following table shows the output of Good X and Good Y per unit of resources in Country
A and Country B.
Country A
Country B

Good X (units)

Good Y (units)

8
2

10
6

Which terms of trade is mutually beneficial to the two countries?


A. 1X = 1Y
B. 2X = 5Y
C. 3X = 9Y
D. 4X = 15Y
5*.
The following table shows the output of computers and watches per unit of resources in
Country A and Country B.
Country A
Country B

Computers (units)

Watches (units)

2
4

10
8

Suppose the exchange ratio is 1 unit of computers to 4 units of watches. Which of the
following is correct?
A. Country A gains 2 units of watches per unit of computers imported.
B. Country B gains 0.25 units of computers per unit of watches exported.
C. The total gain from trade per unit of computers transacted is 2 units of watches.
D. If the total transaction cost per unit of watches is 0.5 units of computers, there will
be no trade in watches.

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Questions and Answers to Exercises (Chapter 11)

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6**.
The following table shows the number of man-hours required by Countries A, B and C in
the production of consumer goods and producer goods.

Country A
Country B
Country C

1 unit of
consumer goods

1 unit of
producer goods

1 man-hour
2 man-hours
3 man-hours

5 man-hours
4 man-hours
3 man-hours

If 1 unit of consumer goods can be exchanged for 0.6 units of producer goods,
A. Country A will export consumer goods and import producer goods.
B. Country B will import both consumer goods and producer goods.
C. Country C will export both consumer goods and producer goods.
D. We cannot determine the pattern of trade in a three-country case.

Short Questions
1.
a. Define absolute advantage and comparative advantage.
(4 marks)
b**. A country can have an absolute advantage in the production of all goods but it cannot
have a comparative advantage in the production of all goods. Do you agree? Explain.
(6 marks)
2.
a. State the principle of comparative advantage.
(2 marks)
b*. Specialisation raises the total world output while trade distributes the increased output
between trading partners. Do you agree? Explain.
(6 marks)
3*.
Comparative advantage determines the direction of trade, the terms of trade, the volume of
trade and the gains from trade. Do you agree? Explain.
(6 marks)

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Questions and Answers to Exercises (Chapter 11)

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Structured Questions
1*.
Suppose the amount of resources in Country X is double that in Country Y and both use ALL
their resources in production. Their maximum output in a year is shown below.
Consumer goods
Producer goods
(units)
(units)
Country X
Country Y
a.
b.
c.

d.

100
30

OR
OR

100
45

Which country has an absolute advantage in the production of consumer goods and
producer goods, respectively? Explain.
(4 marks)
Which country has a comparative advantage in the production of consumer goods and
producer goods, respectively? Explain.
(6 marks)
If 1 unit of consumer goods can be exchanged for 1.25 units of producer goods, what are
the gains for Country X and Country Y for each unit of consumer goods transacted?
(4 marks)
Determine the range of terms of trade of consumer goods and producer goods which is
mutually beneficial to both countries.
(2 marks)

2*.
The following table shows the amount of labour required to produce one unit of Good X and
one unit of Good Y in Country A and Country B, respectively.
Country A
Country B

Good X

Good Y

1
2

3
4

a.

Which country has an absolute advantage in the production of Good X and Good Y,
respectively? Explain.
(4 marks)
b. Which country has a comparative advantage in the production of Good X and Good Y,
respectively? Explain.
(6 marks)
c. If the terms of trade is 1X = 0.4Y, what are the gains for Country A and Country B for
each unit of Good Y transacted?
(5 marks)
d. What will the minimum transport cost of Good Y be for trading not to be beneficial?
(2 marks)
e. Suppose the transport cost of 1Y is 0.4X and is shared equally between the two countries.
What is the range of the terms of trade of 1Y for trade to be mutually beneficial?
(2 marks)

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Answers
P.124
Think it over
Hong Kong cannot produce them or other countries can produce them at a lower cost.
P.126
Discuss 11.1
Although Country A has a higher productivity than Country B in the production of all goods,
Country As productivity in food production is 3.33 times (= 10F 3F) that of Country B but
its productivity in clothing production is only 1.33 times (= 8C 6C) that of Country B.
If Country A uses its resources to produce clothing, it cannot use the same resources to
produce food. Hence, Country A should not produce all goods in which it has an absolute
advantage. Instead, it should allocate its resources to produce the good in which it has a
comparative advantage so that its resources can be used more efficiently.
On the other hand, although Country B has a lower productivity than Country A in the
production of all goods, if it produces nothing, it has nothing to consume. Among all the
goods in which it has an absolute disadvantage, it should produce the good in which it has a
comparative advantage.
Discuss 11.2
No, Country A does not have comparative advantages in the production of all goods. (For a
numerical illustration, refer to the section below. For a mathematical proof, refer to Extension
Corner Section 1.)
P.127
Discuss 11.3
It is comparative advantage, rather than absolute advantage, that determines international
specialisation and trade. This is because absolute advantage tells nothing about which good is
more beneficial for a country to produce, whereas comparative advantage does. This is
explained in Extension Corner Section 2.

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P.130
Test Yourself 11.1
Refer to Table 11.3. Country A has an absolute advantage in both food production and
clothing production, while it has a comparative advantage in the former but a comparative
disadvantage in the latter.
Moreover, Country A has a comparative advantage as well as an absolute advantage in food
production, while Country B has a comparative advantage but an absolute disadvantage in
clothing production.
Hence, absolute advantage and comparative advantage are unrelated.
P.132
Test Yourself 11.2

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Questions and Answers to Exercises (Chapter 11)

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P.132
Discuss 11.4
a. When the terms of trade is 1F to 0.5C, the international price of food is lower than the
production costs in both countries (0.8C and 2C). Both would want to import food from
the world market. However, without sellers, no trade can take place.
b. When the terms of trade is 1F to 0.8C, the international price of food is equal to the
production cost in Country A. As Country A cannot benefit from trade, it may refuse to
trade. In that case, no trade occurs as only one participant (Country B) exists.
c. When the terms of trade is 1F to 2.5C, the international price of food is higher than the
production costs in both countries (0.8C and 2C). Both would want to export food to the
world market. However, without buyers, no trade occurs.
P.143-146
Exercises
Multiple Choice Questions
1. D
Option D: A country has a comparative disadvantage over another country in the
production of a good if it produces the good at a higher opportunity cost than the other
country.
2. C
Option A is incorrect. It implies that Country A has an absolute advantage (rather than a
comparative advantage) over Country B in the production of Good X.
Option B is incorrect. In a two-good case, the production cost of Good X is in terms of
Good Y while that of Good Y is in terms of Good X. The two production costs cannot be
compared. Moreover, comparative advantage concerns the production costs of a good in
two different countries, instead of the production costs of two goods in one country.
Option C is correct. Since Country A has a comparative advantage (a lower opportunity
cost) over Country B in the production of Good X, Country A must have a comparative
disadvantage over Country B in the production of the other good (Good Y).
Option D is incorrect. Comparative advantage or disadvantage are unrelated to
absolute advantage or disadvantage.

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3.

4.

5.

6.

D
Options A and B: Country A can produce 8X or 2Y per unit of resources, while Country
B can produce 10X or 6Y. Both are smaller in A than in B. Hence, Country A (B) has an
absolute disadvantage (advantage) over the other country in the production of both Good
X and Good Y.
Options C and D: The production cost of 1X is 0.25Y (= 2Y 8) in Country A and 0.6Y
(= 10Y 6) in Country B. Hence, Country A (B) has a comparative advantage
(disadvantage) over the other country in the production of Good X. This also implies
that Country A (B) has a comparative disadvantage (advantage) over the other country in
the production of Good Y.
B
The production cost of 1X is 1.25Y (= 10Y 8) in Country A and 3Y (= 6Y 2) in
Country B.
For option A, both would want to import Good X. Without a seller, no trade can take
place.
For option B, the terms of trade is 2X = 5Y or 1X = 2.5Y and Country A will be the
exporter while Country B will be the importer. Trade is mutually beneficial.
For option C, the terms of trade is 3X = 9Y or 1X = 3Y and Country B would have no
gain from trade. It may refuse to trade.
For option D, the terms of trade is 4X = 15Y or 1X = 3.75Y and both would want to
export Good X. Without a buyer, no trade can take place.
D
Let C be computers and W be watches.
Option A is incorrect. The production cost of 1C is 5W (= 10W 2) in Country A and
2W (= 8W 4) in Country B. If the exchange ratio is 1C = 4W, Country A would import
computers and gain 1W (= 5W 4W) per unit of computers imported, while Country B
would export computers and gain 2W (= 4W 2W) per unit of computers exported.
Option B is incorrect. The production cost of 1W is 0.2C (= 2C 10) in Country A and
0.5C (= 4C 8) in Country B. If the exchange ratio is 1W = 0.25C (= 1C 4), Country
A would export watches and gain 0.05C (= 0.25C 0.2C) per unit of watches exported,
while Country B would import watches and gain 0.25C (= 0.5C 0.25C) per unit of
watches imported.
Option C is incorrect. The total gain from trade per unit of computers transacted is 3W
(= 5W 2W = 1W + 2W).
Option D is correct. The total gain from trade per unit of watches transacted at zero
transport and transaction costs is 0.3C (= 0.5C 0.2C). As the total gain is smaller than
the total transaction cost of 0.5C, there will be no trade in watches.
A

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The production costs of consumer goods (C) and producer goods (P) in the three
countries are listed in the table below.
Production cost of 1 unit of
consumer goods

Production cost of 1 unit of


producer goods

Country A

0.2P (= 1 man-hour
5 man-hours 1P)

5C (= 5 man-hours
1 man-hour 1C)

Country B

0.5P (= 2 man-hours
4 man-hours 1P)

2C (= 4 man-hours
2 man-hours 1C)

Country C

1P (= 3 man-hours
3 man-hours 1P)

1C (= 3 man-hours
3 man-hours 1C)

If the exchange ratio is 1C = 0.6P or 1.67C = 1P, the pattern of trade is shown in the
table below.
Consumer goods

Producer goods

Country A

Export
[Cost (0.2P) < Price (0.6P)]

Import
[Cost (5C) > Price (1.67C)]

Country B

Export
[Cost (0.5P) < Price (0.6P)]

Import
[Cost (2C) > Price (1.67C)]

Country C

Import
[Cost (1P) > Price (0.6P)]

Export
[Cost (1C) < Price (1.67C)]

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P. 145
Short Questions
1. a. A country has an absolute advantage over another country in the production of a
good if it can produce a larger amount of the good than the other country with the
same amount of resources. (2 marks)
(Alternative definition of absolute advantage: A country has an absolute advantage
over another country in the production of a good if it can use a smaller amount of
resources to produce the same amount of the good.)
A country has a comparative advantage over another country in the production of a
good if it can forgo a smaller amount of another good than the other country in
producing the same amount of the good. (2 marks)
b. Yes.
With the help of advanced equipment and technology or better human capital, it is
possible that a country has a higher productivity or an absolute advantage in the
production of all goods. (1 mark)
However, in the case of two countries (A and B) and two goods (X and Y), if a
country (Country A) has a comparative advantage (i.e. with a lower opportunity
cost) over another country (Country B) in the production of Good X, Country A
must have a comparative disadvantage over B in the production of Good Y. Hence,
it is impossible for a country to have a comparative advantage over the other
country in all goods. (2 marks)
Proof: Suppose Country A has a comparative advantage over Country B in the
production of X, and Country As production cost of 1X is Y and that of Country
B is Y, then Y < Y (i.e. < ). From the production cost of X, we can derive the
production cost of Y. Country As production cost of 1Y is
production cost of 1Y is

x . Since < ,

x >

x and Country Bs

x . Hence, Country A must

have a comparative disadvantage over Country B in producing Y. (3 marks)

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2.

a.

b.

3.

The principle of comparative advantage states that if each country specialises in


producing the good in which it has a comparative advantage (or lower opportunity
cost), the total world output will increase. (2 marks)
Yes.
According to the principle of comparative advantage, each country should
specialise in producing the good which it has a lower opportunity cost than that of
other countries. By allocating the production of a good (say Good X) from a highcost country to a low-cost country, the total output of the alternative good (say
Good Y) can be increased, and the increase in output is equal to the difference in
production costs between the two countries. Thus, the total world output increases
with specialisation. (3 marks)
If the terms of trade of the two goods lies between the production costs of the two
countries, both the exporting and importing countries can benefit. Each countrys
gain is equal to the difference between the terms of trade and its production cost.
Hence, the gain from specialisation is distributed among countries through trade.
(3 marks)

No.
Comparative advantage determines the direction of trade. The country with a lower
production cost is the exporter while the country with a higher production cost is the
importer. (2 marks)
However, the terms of trade and the volume of trade is determined by the market
demand and market supply of the good in the international market, rather than
determined by comparative advantage. (2 marks)
The unit gains from trade are equal to the difference between the terms of trade and the
production costs of the trading countries. They are not determined by comparative
advantage. (2 marks)

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Structured Questions
1. a. Transform the table given in the question to a table that shows the output of the two
countries with the same amount of resources (by dividing the outputs of Country X
by 2).
Consumer goods
(units)
Country X
Country Y

50 (= 100 2) OR
30
OR

Producer goods
(units)
50 (= 100 2)
45

Since Country X can produce a larger amount of both consumer goods and
producer goods than Country Y with the same amount of resources, Country X has
absolute advantages over Country Y in the production of consumer goods and
producer goods. (4 marks)
b.

Let C be consumer goods and P be producer goods.


Cost of 1C
Country X
Country Y

1P (= 50P 50)
1.5P (= 45P 30)

Cost of 1P
1C (= 50C 50)
0.67C (= 30C 45)

Since 1P < 1.5P, Country X has a comparative advantage over Country Y in the
production of consumer goods. (3 marks)
Since 0.67C < 1C, Country Y has a comparative advantage over Country X in the
production of producer goods. (3 marks)
c.

In Country X, the production cost of 1C (= 1P) is lower than its price (= 1.25P).
Hence, Country X would export consumer goods and gain 0.25P (= 1.25P 1P) per
unit of consumer goods exported. (2 marks)
In Country Y, the production cost of 1C (= 1.5P) is higher than its price (= 1.25P).
Hence, Country Y would import consumer goods and gain 0.25P (= 1.5P 1.25P)
per unit of consumer goods imported. (2 marks)

d.

For mutually beneficial trade, the terms of trade (TOT) should lie between the
production costs of the two countries. Hence, the range of the terms of trade of 1
unit of consumer goods is 1.5P > TOT > 1P, while that of 1 unit of producer goods
is 1C > TOT > 0.67C. (2 marks)

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2.

a.

To produce one unit of Good X, Country A needs 1 unit of labour (L) while
Country B needs 2L. Since 1L < 2L, Country A (requires fewer resources to
produce one unit of Good X) has an absolute advantage over Country B in the
production of Good X. (2 marks)
To produce one unit of Good Y, Country A needs 3L while Country B needs 4L.
Since 3L < 4L, Country A also has an absolute advantage over Country B in the
production of Good Y. (2 marks)

b.
Cost of 1X
Country A
Country B

0.33Y (= 1 3)
0.5Y (= 2 4)

Cost of 1Y
3X (= 3 1)
2X (= 4 2)

Since 0.33Y < 0.5Y, Country A has a comparative advantage over Country B in the
production of Good X. (3 marks)
Since 2X < 3X, Country B has a comparative advantage over Country A in the
production of Good Y. (3 marks)
c.

The terms of trade is 1X = 0.4Y or 2.5X = 1Y. (1 mark)


In Country A, the production cost of 1Y (= 3X) is higher than its price (= 2.5X).
Hence, Country A would import Good Y and gain 0.5X (= 3X 2.5X) per unit of
Good Y imported. (2 marks)
In Country B, the production cost of 1Y (= 2X) is lower than its price (= 2.5X).
Hence, Country B would export Good Y and gain 0.5X (= 2.5X 2X) per unit of
Good Y exported. (2 marks)

d.

Since the gain from trade per unit of Good Y transacted is 1X (= difference in
production costs = 3X 2X), trade would not be beneficial if the minimum
transport cost per unit of Good Y was 1X. This would offset the entire gain.
(2 marks)

e.

Without transport costs, the range of mutually beneficial terms of trade (TOT) of
1Y is 3X > TOT > 2X.
With the equally shared transport cost of 0.4X, the maximum price offered by the
importing country (A) is 3X 0.2X, while the minimum price asked by the
exporting country (B) is 2X + 0.2X. Hence, the new range becomes 2.8X > TOT >
2.2X (= 3X 0.2X > TOT > 2X + 0.2X). (2 marks)

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