Question

Suppose Big Country 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. Comparable figures for Small Nation are 60 units of \(\mathrm{X}\) and 60 units of \(\mathrm{Y}\). Assuming constant costs, in which product should each nation specialize? Explain why. What are the limits of the terms of trade between these two countries? How would rising costs (rather than constant costs) affect the extent of specialization and trade between these two countries?

Short answer

Big Country should specialize in X, and Small Nation should specialize in Y. Terms of trade are values between 0.75Y to 1Y for X, and 1X to 1.33X for Y. Rising costs would reduce specialization and trade benefits.

Step-by-step solution

Identify Opportunity Costs

Calculate the opportunity cost of producing one unit of each product in both countries. For Big Country, they can either produce 80 units of X or 60 units of Y. Therefore, the opportunity cost of producing 1 unit of X is \( \frac{60}{80} = 0.75 \) units of Y, and the opportunity cost of producing 1 unit of Y is \( \frac{80}{60} = 1.33 \) units of X. For Small Nation, they can produce 60 units of either X or Y. Thus, for Small Nation, the opportunity cost of producing 1 unit of X is 1 unit of Y, and the opportunity cost of producing 1 unit of Y is 1 unit of X.

Determine Specialization

A country should specialize in the product for which it has a lower opportunity cost. Big Country has a lower opportunity cost in producing X (0.75 units of Y). Conversely, Small Nation has similar costs for both, but since Big Country is specializing in X and they are equally capable, Small Nation will specialize in Y to optimize total production through shared trading benefits.

Establish Terms of Trade

The terms of trade must be between the opportunity costs for both countries. Big Country's opportunity cost for producing X is 0.75Y, and for Small Nation, it is 1Y for X. So a suitable terms of trade for X would be between 0.75Y and 1Y. Similarly, for Y, the range would be between 1X and 1.33X.

Analyze Effects of Rising Costs

If costs were rising rather than constant, specialization would decrease, as the advantage from trading would diminish. Each country would have to allocate more resources towards the product they specialize in, which may lead to less efficient overall production. As such, trade might still happen, but at a reduced level due to increased costs altering the feasible benefits.

Key concepts

Opportunity Cost

Opportunity cost is a fundamental concept in economics that helps us decide between different options by comparing their relative costs and benefits. When a country, like Big Country or Small Nation, chooses to produce one item, it foregoes the opportunity to produce another. For example, in Big Country, producing one unit of X costs 0.75 units of Y. Conversely, producing one unit of Y costs 1.33 units of X. This comparison shows us what each unit lost is worth in terms of the other good. Meanwhile, Small Nation has an opportunity cost of 1 unit of Y for X and vice versa. This straightforward analysis reveals that different production choices have different associated costs. Understanding opportunity cost enables countries to make more informed decisions about what goods to focus on producing and helps in identifying possible benefits from trade.

Terms of Trade

The terms of trade refer to the rate at which one good can be exchanged for another between countries. It's essential for enabling fair trade by ensuring that both nations benefit from the deal. For Big Country and Small Nation, the terms of trade for X will range between 0.75Y and 1Y. This range ensures both countries can trade without feeling disadvantaged. For Y, the acceptable range lies between 1X and 1.33X. These figures indicate how much of one product each nation is willing to give up for the other. Establishing clear terms of trade ensures that both countries find value in the exchange, promoting healthy economic relationships. It allows nations to consume more than they would in isolation.

Specialization

Specialization occurs when a country focuses on the production of one good in which it has a comparative advantage, allowing it to produce at a lower opportunity cost. Big Country displays a lower opportunity cost for producing X, prompting it to specialize in X production. Small Nation, facing identical costs for both goods but benefiting from Big Country's choice, will specialize in Y. This strategic focus enhances the overall production efficiency of the two countries when they trade together. By specializing, each nation can produce more of their chosen product than if they attempted to make both, thereby increasing potential consumption through trade.

Constant Costs

When we talk about constant costs, we refer to the assumption that the opportunity cost remains the same regardless of the level of production. In this exercise, both Big Country and Small Nation experience constant costs, meaning that producing an additional unit of X or Y has a predictable and unchanging opportunity cost. This predictability simplifies decision-making, as countries can easily calculate their trade benefits. Constant costs facilitate stable and advantageous specialization and trading relationships because they provide a steady frame for evaluating trade-offs and production decisions.

Rising Costs

Rising costs pose a different scenario where producing additional units becomes progressively more expensive, altering the advantage of specialization. In both Big Country and Small Nation, if costs were rising, specialization might decline. As the production of a focused good increases, additional resources would become more costly, potentially reducing the benefits gained from specializing and trading. This would make countries less willing to specialize entirely, lowering the extent of international trade and reducing the gains that come from obtaining goods at lower opportunity costs.

International Trade

International trade involves the exchange of goods and services between countries, allowing nations to obtain products they do not produce efficiently. Through trade, countries like Big Country and Small Nation can consume beyond their production possibilities. By leveraging comparative advantages, international trade encourages optimal resource use globally. It creates a situation where countries specialize in producing goods efficiently and trade for what others produce better. This interdependence fosters global economic growth and improves overall well-being. The exercise of trade reflects the principles of comparative advantage, showing how specialization can enhance worldwide production capacity.