Question

Innovation and Trading City

   In the Stitch and Squeeze example, suppose the shoe output per hour in Stitch increases to 16 and the exchange rate increases to 4 shoes per gallon of milk. A Stitch household switches 1 hour of production time, and a Squeeze household switches 2 hours of production time.

Ignoring any transaction cost, what are the gains from trade for each type of household?

If the exchange time is 1/4 hour, what are the gains from trade for each type of household?

Answer 1

A Stitch household switches 1 hour of production time, i.e, it can produce 16 units of shoes in 1 hour.

Also, the Squeeze household switches to 2 hours of production time.

Now, given exchange rate is 4 shoes per gallon of milk.

If both trades such that, there is no transaction cost, Squeeze produces 16/4 = 4 gallons of milk in 2 hours.

Hence, Stitch household will export 4 units of shoes and consumes 16-4 = 12 units of shoes after trade . Thus, it will gain 1 gallon of milk for 4 units of shoes.

Similarly, Squeeze household will export 4/4 = 1 gallon of milk and consume remaining 3 gallons of milk. Thus, it will gain 4 units of shoes for 1 gallon of milk.

Now, if the exchange time is 1/4 hour, Stitch household produces 16 units of shoes in an hour whereas, Squeeze household produces 2 gallons of milk in an hour. Thus, Stitch household will exchange 16/4 = 4 units of shoes for 2/4 = 0.5 gallons of milk from Squeeze household.