Question

Adama and Benny are two hermits, living far away from the rest of society. They only care about two goods Chestnuts and Dates. They can only produce one good at a time, and the table below shows how much of each good they can produce if they spend 1 hour on it. Chestnuts Dates | Adam 6 13 Benny 5 1 1 1 (a) There are no costs to trading. Give the range of all possible prices at which trade could occur. State your answer in terms of the price of Dates. Now, suppose instead that there are transaction costs to selling Dates: for every Date that reaches the market, 0.5 Dates fall out along the way. There are no transaction costs to selling Chestnuts. (b) What is the price range for dates where Adama will consent to trade? (c) What is the price range for dates where Benny will consent to trade? (d) Could trade still occur with these transaction costs?

Answer 1

Adama can produce 6 chestnuts or 3 dates in one hour.

Adama's opportunity cost of producing chestnuts = 3/6 dates per chestnut = 0.5 dates per chestnut

and Adama's opportunity cost of producing dates = 6/3 chestnuts per dates = 2 chestnuts per dates

Again, Benny can produce 5 chestnuts or 1 dates in one hour

Benny's opportunity cost of producing chestnuts = 1/5 dates per chestnut = 0.2 dates per chestnut

and Benny's opportunity cost of producing dates = 5/1 chestnuts per dates = 5 chestnuts per dates

As opportunity cost of producing chestnuts is lower for Benny, Benny has comparative advantage in the production of chestnuts. Again, as opportunity cost of producing dates is lower for Adama, Adama has comparative advantage in the production of dates.

Under trade, Adama will produce dates and Benny will produce dates.

a) Trade will happen in between the range 0.2 dates per chestnut and 0.5 dates per chestnut.

b) If 0.5 dates fall along the way for every date in the market,

then, Adama's opportunity cost of producing chestnuts = 1.5/6 dates per chestnut = 0.25 dates per chestnut

and Adama's opportunity cost of producing dates = 6/1.5 chestnuts per dates = 4 chestnuts per dates

Then, Adama will trade if price for dates is lower than 0.25 dates per chestnut.

c) However, Benny will trade at a price greater than 0.2 dates per chestnut (no change in price).

d) Trade will only occur between the range 0.2 dates per chestnut and 0.25 dates per chestnut.