Question

1. Countries A and B both can produce two goods, X and Y. If country A produces only good X, it can produce 30 units of X; if country A produces only good Y, it can produce 10 units of Y. If country B produces only good X, it can produce 40 units of X; if country B produces only good Y, it can produce 40 units of Y. Assume that both countries have homogenous resources so that the opportunity costs remain constant. a. What are countries A's and B's opportunity costs of producing both goods? b. Who has a comparative advantage in producing these two goods? c. Suppose that without trade, country A would produce 15 units of X and 5 units of Y, and country B would produce 20 units of X and 20 units of Y. Please explain how trade can benefit both countries. d. What is the possible range of the terms of trade for voluntary trade to take place?

Answer 1

a. Country A's opportunity cost of producing X = units of Y sacrificed/units of X produced = 10/30 = 0.33

and country A's opportunity cost of producing Y = units of X sacrificed/units of Y produced = 30/10 = 3

Similarly, country B's opportunity cost of producing X = units of Y sacrificed/units of X produced = 40/40 = 1

and country B's opportunity cost of producing Y = units of X sacrificed/units of Y produced = 40/40 = 1

b. As opportunity cost of producing X is lower for country A, country A has comparative advantage in the production of good X.

Again as opportunity cost of producing Y is lower for country B, country B has comparative advantage in the production of good Y.

c. Initially, without trade, country A is producing 15 units of good X and 5 units of good Y whereas, country B is producing 20 units of good X and 20 units of good Y.

For trade, country A will produce 30 units of good X only whereas, country B will produce 40 units of good Y only (according to their comparative advantage).

Here, let us suppose that trade takes place at a rate of 0.5 units of Y per unit of X.

Then, if country A consumes 15 units of good X, it can trade remaining 15 units of good X to country B and in return gains 7.5 units of good Y.

Similarly, if country B consumes 20 units of good Y, it can trade remaining 20 units of good Y to country A and in return gains 40 units of good X.

Thus, country A gains 2.5 units of good Y and country B gains 20 units of good X from trade.

d. The possible range of TOT is between opportunity cost of producing X between both countries i.e, 0.33 units of Y per unit of X and 1 unit of Y per unit of X.