Question

5. The price of trade

Suppose that Spain and Germany both produce fish and wine. Spain's opportunity cost of producing a bottle of wine is 3 pounds of fish while Germany's opportunity cost of producing a bottle of wine is 11 pounds of fish.

By comparing the opportunity cost of producing wine in the two countries, you can tell that   has a comparative advantage in the production of wine and   has a comparative advantage in the production of fish.

Suppose that Spain and Germany consider trading wine and fish with each other. Spain can gain from specialization and trade as long as it receives more than   of fish for each bottle of wine it exports to Germany. Similarly, Germany can gain from trade as long as it receives more than   of wine for each pound of fish it exports to Spain.

Based on your answer to the last question, which of the following prices of trade (that is, price of wine in terms of fish) would allow both Germany and Spain to gain from trade? Check all that apply.

2 pounds of fish per bottle of wine

1 pound of fish per bottle of wine

5 pounds of fish per bottle of wine

7 pounds of fish per bottle of wine

Answer 1

Solution:

Opportunity cost means the amount of one good given up in order to increase production of another good by a single unit (due to resource constraints). In this sense, opportunity cost of producing a bottle of wine is simply the quantity of fish production given up/sacrificed for an additional wine bottle.

As Spain's opportunity cost of producing a bottle of wine is lower than that of Germany (3 < 11), or a lower quantity of fish is required to be sacrificed in Spain, it can be concluded that Spain has a comparative advantage in wine production, while Germany has a comparative advantage in fish production (opportunity coat for fish production can be calculated as reciprocal of opportunity cost of wine production, so (1/3) > (1/11)).

Since, Spain can produce a bottle of wine in replacement of 3 pounds of fish, to gain from trade, it must receive at least more than 3 pounds of fish. Similarly, seeing the opportunity cost of fish production for Germany = 1/11 bottles of wine, Germany must receive at least (1/11) bottle of wine for each pound of fish exported to Spain.

As we have already seen that to gain from trade, at least 3 pounds of fish must be exchanged for a bottle of wine, the correct options are (c) and (d): 5 pounds of fish per bottle of wine, 7 pounds of fish per bottle of wine.