Suppose that Maldonia and Lamponia agree to trade. Each country focuses its resources on producing only the good in which it has a comparative advantage. The countries decide to exchange 24 million pounds of potatoes for 24 million pounds of coffee. This ratio of goods is known as the price of trade between Maldonia and Lamponia.
The Correct Answer and Explanation is:
Correct Answer:
The price of trade between Maldonia and Lamponia is 1 pound of potatoes for 1 pound of coffee.
In the context of international trade, comparative advantage is the key principle that allows countries to benefit from specializing in the production of goods for which they have the lowest opportunity cost, and then trading for other goods.
Here, Maldonia and Lamponia have agreed to trade 24 million pounds of potatoes for 24 million pounds of coffee. The price of trade (also called the terms of trade) refers to the rate at which one good is exchanged for another between two countries.
To determine this, we look at the ratio at which the goods are exchanged. In this scenario:
- 24 million pounds of potatoes are traded for 24 million pounds of coffee.
- This implies that 1 pound of potatoes is being exchanged for 1 pound of coffee.
So, the price of trade is 1:1 — one pound of potatoes per one pound of coffee.
This trade ratio falls between the countries’ opportunity costs, assuming that each country has a comparative advantage in producing one of the goods. For instance, if Maldonia can produce coffee at a lower opportunity cost than potatoes, and Lamponia can produce potatoes at a lower opportunity cost than coffee, both countries benefit by specializing and trading.
The agreed price of trade (1:1) must be mutually beneficial, meaning it should lie between the opportunity costs each country faces domestically. If, for example, Maldonia can produce 1 pound of coffee by giving up only 0.5 pounds of potatoes, then getting 1 pound of potatoes for 1 pound of coffee through trade is advantageous. Similarly, if Lamponia gives up 2 pounds of coffee for every pound of potatoes it produces, receiving 1 pound of coffee for 1 pound of potatoes through trade is also beneficial.
Thus, the trade enables gains from specialization and exchange, improving overall efficiency and output.
