Question

Question on Absolute Advantage:

18. Adam Smith's absolute advantage theory had flaws. You could use his own theory to argue that England should not drop the trade barriers imposed to Latin America. With this goal in mind, what values of X and Y would make your argument valid? Sector A Sector B Latin America 1 unit per day 5 units per day England X units per day Y units per day

Answer 1

Answer: value of X - 2 and Y - 6.

Assumption: In order to prove the flaws in Adam Smith's theory of absolute advantage, we should argue that England should continue the trade barriers to Latin America.

To work out the above assumption,England should be shown as not benefiting from trade with Latin America in terms of (a) opportunity cost, and (b) trade barriers.

As per the given data, Latin America has opportunity cost of 5 units in Sector A and 1/5 units in Sector B. That is, Latin America has to sacrifice 5 units of Sector B to produce 1 unit of Sector A and 1/5 unit of Sector A to produce a unit of Sector B.

So England should have lower opportunity cost, at least in one sector. That is, less than 5 in sector A or less than 1/5 in sector B. For example, value of X can be 2 and value of y can be 6.

Now, the opportunity cost of sector A would be 6/2= 3 units of Sector B per one unit of Sector A (less than LA), and

the opportunity cost of Sector B will be 2/6 = 1/3 units of Sector A per on unit of Sector B (slightly more than LA).

Now England has comparative advantage over Latin America in the production of Sector A and Latin America has comparative advantage in the production of Sector B.

However, trade barriers will be imposed by England in the form of import duties and/ or other taxes which will make the Sector B products from Latin America more expensive. Hence, England should not drop trade barriers.