Q4. Suppose Big Country can produce ... [FREE SOLUTION]

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Chapter 20: Q4. (page 430)

Suppose Big Country can produce 80 units of X by using all its resources to produce X or 60 units of Y by devoting all its resources to Y. Comparable figures for Small Nation are 60 units of X and 60 units of Y. Assuming constant costs, in which product should each nation specialize? Explain why. What are the limits of the terms of trade between these two countries?

Short Answer

Expert verified

Big Country should produce X, and Small Nation should produce Y.

The limits of terms of trade are dependent on the opportunity cost of production.

Step by step solution

Step 1. Opportunity cost

The opportunity cost of producing X good is calculated below:

$B i g c o u n t r y = \frac{60}{80} = 0.75 Y S m a l l N a t i o n = \frac{60}{60} = 1 Y$

The opportunity cost of producing Y good is calculated below:

$B i g C o u n t r y = \frac{80}{60} = 1.33 X S m a l l N a t i o n = \frac{60}{60} = 1 X$

As the opportunity cost of production is less for X in Big Country than Small Nation, the latter has a lower opportunity cost for Y than Big Country; hence, Big Country should produce X, and Small Nation should produce Y.

Step 2. Terms of trade

Terms of trade are the exchange ratio for the X and Y. Big Country will never agree to pay more than 1.33 units of good X for a unit good Y; then, it can produce itself. Small Nation will not accept less than 1 unit of good X for a unit of good Y, as it can produce either good X or good Y. The limit for terms of trade will be in between 1 unit of good X for 1 unit of good Y and 1.33 units of good X for 1 unit of good Y.