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Micro Economic Principles - Assignment Example

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Answer 1. Adam Smith, in his book Wealth of Nations, had explained the importance of free trade by pointing out that it is foolishness to produce something at home which can be brought from the market at a lower cost than the actual cost of production. COUNTRIES CLOTHING (labour hours per unit) FOOD (labour hours per unit) U.S…
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Micro Economic Principles
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Micro Economic Principles

Download file to see previous pages... Therefore, according to Adam Smith, absolute cost difference provides the basis for international trade. (In this example labour hour is taken to be the only resource of production.) David Ricardo had later extended the above said idea by pointing out that it is comparative advantage and not absolute advantage that forms the basis of international trade. COUNTRIES CLOTHING (labour hours per unit) FOOD (labour hour per unit) RELATIVE COSTS (C/F) RELATIVE COSTS (F/C) U.S. 8 hours/unit 10 hours/unit 0.8 hours/unit 1.25 hours/unit INDIA 10 hours/unit 15 hours/unit 0.67 hours/unit 1.5 hours/unit Here, it can be seen that India has an inferior productivity compared to U.S. in both the goods. In the absence of trade both the nations will have to produce both the goods in order to meet the local demands. But, in the presence of trade, India should produce only clothing as it has a lower opportunity cost. Again, U.S. should specialize in food because here food has a lower opportunity cost. Opportunity cost is the cost incurred when a choice is made, in terms of the next best available option. In the above stated example, India by producing 1 unit of Clothing is losing out on 0.67 units of food but if India were to produce food, then by producing 1 unit of food, India would have lost out on 1.5 units of clothing. Therefore, a country should specialize in a good that has a lower opportunity cost. Considering 100 hours of labour, the figure below shows the gains from trade: For U.S., For India, Production possibility frontier or the production possibility curve is a curve representing the tradeoff between two commodities given the resources is efficiently utilized. The PPC shows the maximum amount of one commodity that can be obtained given fixed amount of second commodity. Terms of trade is (price of exports)/ (price of imports). It is the quantity imports which can be purchased using a certain fixed amount of exports. Trade line is the line representing the terms of trade. Gains from trade are the gains that result from specialization and trade arrangements between two countries. In this example, both U.S. and India are gaining from this arrangement. The price of food post trade will be between 1.25-1.50 and the price for clothing will be between 0.67-0.80. This proves that trade will be beneficial for both the countries. (Pugel, n.d.; Krugman, 2007) Answer 2. a) Given, MPC= 10+10Q P= 70 – 5Q The private market equilibrium will have the MPC = P or, 10+ 10Q = 70 -5Q or, 15Q= 60 therefore, Q’ = 4 substituting the value of Q in the demand equation we get, P = 70 – 5*(4) or, P’ = 50. b) Given, MSC= 10 + 12Q P= 70 -5Q The social market equilibrium will have the MSC = P or, 10 + 12Q = 70 – 5Q or, 17Q = 60 therefore Q*= 3.53 (approx) [socially optimum Q] substituting the value of Q in the demand equation we get, P= 70 -5*(3.53) or, P*= 52.35 [socially optimum P] (Varian, 2010) The equilibrium in (a) is not optimal because in case of negative externalities, marginal social cost > marginal private cost. The diagram above shows that for a profit maximizing producer, for a given cost, the profit maximizing output is Q’ which is greater than the socially optimum output Q*. By producing at Q’, the producer is causing an externality worth AB which the producer is not treating as a cost. (Varian, 2010) The equilibrium in (b) is optimal because here the cost of externality is also ...Download file to see next pagesRead More
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