Comparative Advantage and Trade: Milk and Beer (US vs Peru)

A set of practice flashcards covering absolute and comparative advantage, opportunity costs, specialization, terms of trade, and post-trade outcomes using the US vs Peru milk-and-beer example.

What is absolute advantage?

The ability of a country to produce a good using fewer resources (labor hours) than another country.

Which country has absolute advantage in milk in the US vs Peru scenario?

The United States, since it takes 4 hours to produce a gallon of milk (versus 5 hours in Peru).

Which country has absolute advantage in beer in the US vs Peru scenario?

The United States, since it takes 2 hours to produce a gallon of beer (versus 5 hours in Peru).

What is comparative advantage?

The ability to produce a good at a lower opportunity cost than the other country.

In this example, which good does the US have a comparative advantage in?

Beer, because the US has a lower opportunity cost for beer (0.5 milk per beer) than Peru (1 milk per beer).

In this example, which good does Peru have a comparative advantage in?

Milk, because Peru has a lower opportunity cost for milk (1 beer per gallon) than the US (2 beers per gallon).

What are the US's opportunity costs for producing milk and beer?

Milk costs 2 beers; Beer costs 0.5 gallons of milk.

What are Peru's opportunity costs for producing milk and beer?

Milk costs 1 beer; Beer costs 1 gallon of milk.

What condition must the terms of trade satisfy for mutual gains?

The exchange rate of beer for milk must lie between the two countries' opportunity costs: between 0.5 and 1 gallon of milk per beer.

Why do countries gain from trade even if one has absolute advantage in both goods?

Because trade can be based on comparative advantage; each country can specialize where its opportunity costs are lower and both can be better off.

What is the expected specialization under these numbers?

USA should specialize in beer and Peru should specialize in milk (based on comparative advantage).

What are the post-trade consumption levels for the United States in this example?

30 gallons of beer and 13 gallons of milk after trade.

What are the post-trade consumption levels for Peru in this example?

20 gallons of beer and 7 gallons of milk after trade.

What is meant by 'exports' in the context of trade?

Goods produced domestically and sold to other countries.

What does it mean for resources to be 'inside' the production possibilities frontier?

There are idle resources (e.g., hours) that could be reallocated to produce more of either good, indicating underutilization.

What is specialization in this context?

Allocating resources to the good for which a country has a comparative advantage.