Question

The Dominican Republic and Nicaragua both produce coffee and rum. The Dominican Republic can produce 20 thousand tons of coffee per year or 10 thousand barrels of rum. Nicaragua can produce 30 thousand tons of coffee per year or 5 thousand barrels of rum. [LO 2.3] a. Suppose the Dominican Republic and Nicaragua sign a trade agreement in which each country would specialize in the production of either coffee or rum. Which country should specialize in coffee? Which country should specialize in producing rum? b. What are the minimum and maximum prices at which these countries will trade coffee?

Short answer

Nicaragua should specialize in coffee, and the Dominican Republic in rum. Trade prices for coffee should be between 0.167 and 0.5 barrels of rum per ton.

Step-by-step solution

Determine Opportunity Costs

We need to calculate the opportunity cost of producing coffee in terms of rum for both countries. The opportunity cost of producing 1 unit of coffee for the Dominican Republic is \( \frac{10}{20} = 0.5 \) barrels of rum. For Nicaragua, the opportunity cost of producing 1 unit of coffee is \( \frac{5}{30} \approx 0.167 \) barrels of rum.

Evaluate Comparative Advantage

The country with the lower opportunity cost for a good has a comparative advantage. Since Nicaragua's opportunity cost for coffee (0.167 barrels of rum) is lower than that of the Dominican Republic (0.5 barrels of rum), Nicaragua should specialize in producing coffee.

Determine Opportunity Costs for Rum

Next, calculate the opportunity cost of producing rum in terms of coffee. For the Dominican Republic, the opportunity cost of producing 1 barrel of rum is \( \frac{20}{10} = 2 \) tons of coffee. For Nicaragua, the opportunity cost is \( \frac{30}{5} = 6 \) tons of coffee.

Determine Specialization in Rum

The Dominican Republic has a lower opportunity cost for producing rum (2 tons of coffee) compared to Nicaragua (6 tons of coffee). Therefore, the Dominican Republic should specialize in producing rum.

Calculate Minimum and Maximum Trade Prices

The trade price of coffee must fall between the opportunity costs of both countries. The minimum price of coffee should be at least Nicaragua's opportunity cost, 0.167 barrels of rum, so it is worthwhile for them. The maximum price should be up to 0.5 barrels of rum (the Dominican Republic's opportunity cost), beyond which the Dominican Republic would rather produce coffee themselves.

Key concepts

Opportunity Cost

Opportunity cost is a key concept in economics and plays a significant role in decision-making. It refers to the cost of foregoing the next best alternative when making a choice. In our exercise, we explore opportunity cost in terms of coffee and rum production for two countries—the Dominican Republic and Nicaragua.
To illustrate, if the Dominican Republic decides to produce coffee, the opportunity cost is the amount of rum they could have produced instead. Calculating this, we find that producing 1 ton of coffee costs the Dominican Republic 0.5 barrels of rum. This means they give up making 0.5 barrels of rum for every ton of coffee they produce.
Comparatively, Nicaragua gives up only 0.167 barrels of rum per ton of coffee. Here, Nicaragua has a lower opportunity cost for producing coffee. This lower cost indicates that Nicaragua can produce coffee more efficiently relative to rum, implying comparative advantage in coffee production.

Specialization

Specialization occurs when a country focuses its resources on producing a particular good, leading to higher efficiency and productivity. It is based on the principle of comparative advantage, which is determined by opportunity costs.
In our scenario, Nicaragua has a comparative advantage in coffee production because it has a lower opportunity cost compared to the Dominican Republic. By focusing on coffee, Nicaragua can produce more coffee efficiently. On the other hand, the Dominican Republic should specialize in rum production, as its opportunity cost for rum is lower (2 tons of coffee per barrel of rum) than Nicaragua's (6 tons of coffee per barrel of rum).
Through specialization, each country can maximize its production output, contributing to overall increased economic efficiency. This setup allows both countries to benefit when they engage in trade, as they become better at producing specific goods and trade for others.

Trade Agreement

A trade agreement often follows specialization, facilitating the exchange of goods between countries. It allows each country to concentrate on producing goods where they hold a comparative advantage, and trade for others, thereby optimizing resources.
In the exercise, a trade agreement forms between the Dominican Republic and Nicaragua. Each country benefits by trading goods they specialize in. Nicaragua, specializing in coffee, trades with the Dominican Republic, which specializes in rum. This trade is governed by a mutual agreement on trade prices.
The trade price for coffee should be between 0.167 barrels of rum (Nicaragua's opportunity cost) and 0.5 barrels of rum (the Dominican Republic's opportunity cost). This range ensures that both countries gain from trade as it allows each to sell at a profit compared to producing the goods domestically. Such agreements enhance economic ties and lead to more efficient resource allocation globally.