Terms of trade Suppose that Greece and Austria both produce fish and cheese. Gre

Question

Terms of trade Suppose that Greece and Austria both produce fish and cheese. Greece's opportunity cost of producing a pound of cheese is 4 pounds of fish while Austria's opportunity cost of producing a pound of cheese is 10 pounds of fish. By comparing the opportunity cost of producing cheese in the two countries, you can tell that has a comparative advantage in the production of cheese and has a comparative advantage in the production of fish. Suppose that Greece and Austria consider trading cheese and fish with each other. Greece can gain from specialization and trade as long as it receives more than of fish for each pound of cheese it exports to Austria. Similarly, Austria can gain from trade as long as it receives more than of cheese for each pound of fish it exports to Greece. Based on your answer to the last question, which of the following terms of trade (that is, price of cheese in terms of fish) would allow both Austria and Greece to gain from trade? Check all that apply. 18 pounds of fish per pound of cheese 9 pounds of fish per pound of cheese 1 pound of fish per pound of cheese 3 pounds of fish per pound of cheese

Explanation / Answer

The opportunity cost of producing 1 pound of cheese is 4 pounds of fish in Greece. Similarly, the opportunity cost of producing 1 pound of cheese is 10 pounds of fish in Austria. This means Greece gives up 4 pound of fish in producing 1 pound cheese while Austria gives up 10 pounds of fish.

By a similar argument, the opportunity cost of producing 1 pound of fish is 1/4 or 0.25 pounds of cheese in Greece. Similarly, the opportunity cost of producing 1 pound of fish is 1/10 or 0.10 pounds of cheese in Austria.

Hence, Greece has the comparative advantage in the production of Cheese. Note that the opportunity cost of producing fish is lower in the Austria. Hence, it has the comparative advantage in the production of fish.

If they trade, Greece will be benefitted only if it receives more than 4 pounds of fish which it gives up in producing cheese. Similarly, Austria gives up 0.10 pounds of cheese to produce 1 pound of fish so will be benefitted only if it receives more than 0.10 pounds of cheese which it gives up in producing fish. This means Austria will be willing to pay less than 10 pounds of fish for 1 pound of cheese.

The relative price for trade should lie in between these two values. Hence the correct option is B, 9 pounds of Fishes against 1 pound of Cheese.

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