Question

Assume that the comparative-cost ratios of two products—baby formula and tuna fish—are as follows in the nations of Canswicki and Tunata:

Canswicki: 1 can baby formula ≡ 2 cans tuna fish

Tunata: 1 can baby formula ≡ 4 cans tuna fish

In what product should each nation specialize? Which of the following terms of trade would be acceptable to both nations: (a) 1 can baby formula ≡ 2 1/2 cans tuna fish; (b) 1 can baby formula ≡ 1 can tuna fish; (c) 1 can baby formula ≡ 5 cans tuna fish?

Short answer

Canswicki should specialize in baby formula, and Tunata should specialize in tuna fish.

The term of trade that is accepted will be (a).

Step-by-step solution

Step 1. Comparative advantage

The comparative advantage on any product will be when the opportunity cost of producing the product is less than the competitor.

The opportunity cost of producing baby formula will be:

$$\begin{gathered} Canswicki=\frac{2cansoftunafish}{1canofbabyformula} \\ =2cansoftunafish \\ Tunata=\frac{4cansoftunafish}{1canofbabyformula} \\ =4cansoftunafish \end{gathered}$$

Canswicki has a comparative advantage in the production of baby formula.

The opportunity cost of producing tuna fish will be,

$$\begin{gathered} Canswicki=\frac{1}{2}cansofbabyformula \\ Tunata=\frac{1}{4}cansofbabyformula \end{gathered}$$

Tunata has a comparative advantage in the production of tuna fish.

Step 2. Explanation for acceptable terms of trade

The acceptable terms of trade will be when the opportunity cost of both Canswicki and Tunata will be between the terms of trade.

1. The terms of trade will be acceptable. For Canswicki, if it does not trade, it can produce 2 tuna fish cans for 1 baby formula, and if it trades 1 baby formula, then it can get 2.5 cans of tuna fish; hence by trade, Canswicki is better off. For Tunata, if it does not trade, then it can produce 1 baby formula can for 4 tuna fish cans, and if the trade for 1 baby formula, then 2.5 cans of tuna fish to be given up; hence, it is better off by trade.

2. The terms of trade will not be acceptable. For Canswicki, if it does not trade, it can produce 2 tuna fish cans for 1 baby formula, and if it trades 1 baby formula, then it can get 1 can of tuna fish; hence, it will not trade. They can produce 2 tuna fish cans by giving up 1 baby formula without trade.

3. The terms of trade will be acceptable. For Tunata, if it does not trade, it can produce 1 baby formula can for 4 tuna fish cans, and if they trade for 1 baby formula, then 5 cans of tuna fish will be given up; hence, it is worse off by trade. They can produce 1 baby formula can by giving 4 cans of tuna fish without trade.