Managerial Economics

In Class Exercise Two

Assume you have just become the new manager of a large production facility or "plant".  The plant is broken up into two different "profit centers" - Profit Center A and Profit Center B.  Each profit center could produce either salt or pepper or both and both Centers sell both salt and pepper to their own specific customers.

Assume your plant uses only one factor of production, labor. (I know this is not realistic but it doesn't take away the main point this exercise is trying to make).  It takes 4 labor hours to produce 1 pound of salt, and 1 labor hour to produce 1 pound of pepper in Profit Center A. It takes 8 labor hours to produce 1 pound of salt and 4 labor hours to produce 1 pound of pepper in Profit Center B.

1.  Which Center has an absolute advantage in the production of pepper?  Explain your answer.

a.  Profit Center A
b.  Profit Center B
c.  Both Centers have an absolute advantage in pepper
d.  Neither Center has an absolute advantage in pepper

2.  Which Center has a comparative advantage in the production of pepper?  Explain your answer.

a.  Profit Center A
b.  Profit Center B
c.  Both Centers have a comparative advantage in pepper
d.  Neither Center has a comparative advantage in pepper

Now assume there are 1000 labor hours available in each Center and right now these hours are divided equally between producing salt and pepper. Therefore, there are 500 labor hours available for producing salt and 500 labor hours for producing pepper in both Centers. So before specialization and trade between the two Centers, total plant production of salt and pepper is 187.5 pounds and 625 pounds respectively.

Where did these numbers come from?

Now you decide as a manager to initiate some specialization and trade in your plant.  You set up a system as to where the two Centers can trade with each other (using a pre-determined "transfer price" or trading ratio - see below).  Under your direction, Profit Center B specializes in producing salt and "transfers" 62.5 pounds of salt to Profit Center A (so total production of salt in Profit Center B becomes 125 pounds). With a trading ratio of 3 pounds of pepper to 1 pound of salt, Profit Center A specializes in pepper and transfers 187.5 pounds of pepper to Profit Center B (so total production of pepper in Profit Center A becomes 687.5).

3.  What is total plant (including both Centers) production of salt and pepper after specialization and trade?  Is your plant more productive? Explain your answer.