5 The price of trade Suppose that Italy and Sweden both prod

5. The price of trade Suppose that Italy and Sweden both produce oil and shoes. Italy\'s opportunity cost of producing a pair of shoes is 4 barrels of oil while Sweden\'s opportunity cost of producing a pair of shoes is 10 barrels of oil By comparing the opportunity cost of producing shoes in the two countries, you can tell that has a comparative advantage in the production of shoes and has a comparative advantage in the production of oi Suppose that Italy and Sweden consider trading shoes and oil with each other. Italy can gain from specialization and trade as long as it receives more ? of oil for each pair of shoes it exports to Sweden. Similarly, Sweden can gain from trade as long as it receives more than of shoes for each barrel of oil it exports to Italy than Based on your answer to the last question, which of the following prices of trade (that is, price of shoes in terms of oil) would allow both Sweden and Italy to gain from trade? Check all that apply 1 barrel of oil per pair of shoes 3 barrels of oil per pair of shoes 6 barrels of oil per pair of shoes 9 barrels of oil per pair of shoes

Solution

(a) Italy has comparative advantage in shoes (since Italy can make shoes at a lower opportunity cost (OC) than Sweden can: 4 < 10) and Sweden has comparative advantage in oil.

(b) Trade is beneficial when terms of trade (TOT) lies between the OC in both countries. So,

Italy can gain as long as it receives more than 4 barrels of oil per shoes. Sweden can gain as long as it receives more than 0.1 (= 1/10) shoes.

(c) Beneficial and acceptable TOT are: 4 oil < TOT of shoes < 10 oil. Therefore, following are acceptable:

- 6 barrels of oil per pair of shoes

- 9 barrels of oil per pair of shoes