Question

Suppose nation A 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. Comparative figures for nation B are 60 of X and 60 of Y. Assuming constant costs, in which product should each nation specialize? Why? Indicate the limits of the terms of trade.

Answer 1

Comparative advantage in a good means that a nation will choose to specialize in that good in which it has a lower opportunity cost. And that nation will have a comparative advantage in producing that good in which it has a lower opportunity cost. Opportunity cost is the cost of giving something up for getting something else in return.

We are given that nation A can either produce 80 units of X or 60 units of Y with all its resources.

Nation B can either produce 60 units of X or 60 units of Y with all its resources.

We can write this information in a tabular form:

	Good X	Good Y
Nation A	80	60
Nation B	60	60

The opportunity cost of producing good X in nation A = 60/80 = 0.75

The opportunity cost of producing good Y in nation A = 80/60 = 1.33

The opportunity cost of producing good X in nation B = 60/60 = 1

The opportunity cost of producing good Y in nation B = 60/60 = 1

Thus, we can see that nation A has a comparative advantage in producing good X since it has a lower opportunity cost in producing good X than nation B (0.75<1). Thus, nation A will specialize in good X.

Similarily, nation B has a comparative advantage in producing good Y since it has a lower opportunity cost in producing good Y than nation A (1<1.33). Thus, nation B will specialize in good Y.

The limits of the terms of trade for good X is: (1<X<1.33).

The limits of the terms of trade for good Y is: (0.75<Y<1)