Question

What are the limits of the terms of trade? Specifically, when is Canada willing to trade with Japan, and when is Japan willing to trade with Canada?

Short answer

Answer: Canada and Japan are willing to trade with each other if they can benefit from the exchange by obtaining goods at a lower opportunity cost than by producing them domestically. This occurs when either of the following conditions is met: 1) Canada has a comparative advantage in good A and Japan has a comparative advantage in good B, or 2) Canada has a comparative advantage in good B and Japan has a comparative advantage in good A.

Step-by-step solution

Understanding the Terms of Trade

Terms of trade refer to the rate at which one country exchanges goods or services for the goods or services of another country. In this case, it is the rate at which Canada and Japan exchange their products. It reflects the relative prices that the two countries agree upon to trade.

Determining Opportunity Costs

Opportunity cost refers to the next best alternative that must be given up when making a choice. In the context of international trade, opportunity cost represents the amount of one good that must be given up to produce one more unit of another good. To determine when Canada and Japan are willing to trade with each other, we must compare the opportunity costs of producing goods in both countries. Suppose in Canada, the opportunity cost of producing 1 unit of good A is a_a units of good B, while in Japan, the opportunity cost of producing 1 unit of good A is a_j units of good B. Similarly, suppose that in Canada, the opportunity cost of producing 1 unit of good B is b_a units of good A, and in Japan, the opportunity cost of producing 1 unit of good B is b_j units of good A.

Identifying Comparative Advantage

Comparative advantage exists when a country can produce a good at a lower opportunity cost compared to another country. In our case, Canada has a comparative advantage in producing good A if a_a < a_j and a comparative advantage in producing good B if b_a < b_j. Similarly, Japan has a comparative advantage in producing good A if a_j < a_a and a comparative advantage in producing good B if b_j < b_a.

Determining When Countries Are Willing to Trade

Countries are willing to trade when they can benefit from the exchange by obtaining goods at a lower opportunity cost than by producing them domestically. In our case, Canada is willing to trade with Japan if either of the following conditions is met: 1. Canada has a comparative advantage in good A (a_a < a_j) and Japan has a comparative advantage in good B (b_j < b_a) 2. Canada has a comparative advantage in good B (b_a < b_j) and Japan has a comparative advantage in good A (a_j < a_a) Conversely, Japan will be willing to trade with Canada if either of the aforementioned conditions is met.

Limitations of the Model

Keep in mind, this analysis is based on a simplified model of trade, which assumes perfect competition, no transportation costs, and no barriers to trade. In reality, there are other factors that can affect the willingness of countries to trade with each other, such as political considerations, trade policies, and currency exchange rates. Nonetheless, this analysis provides a basic framework for understanding the limits of the terms of trade and the conditions under which countries are willing to trade.