Quiz 5 Flashcards
Below are the production frontiers for Northland and Southland as also used in the lecture.
If Northland and Southland fully specialise based on their comparative advantages, Northland produces 150 units of clothes, and Southland produces 400 units of food.
What is the opportunity cost of Northland of producing 1 unit of food?
What is the opportunity cost of Southland of producing 1 unit of clothes?
If Northland produces 1 unit of food it will have to give up production of 3/2 units of clothes, which is the opportunity costs of producing 1 unit of food. This leads to an opportunity cost ratio of 1 clothes : 0.667 food (or 1 food: 1.5 clother).
If Southland produces 1 unit of clothes it will have to give up production of 2 units of food, which is the opportunity costs of producing 1 unit of clothes. This leads to an opportunity cost ratio of 1 clothes : 2 food.
These opportunity costs can be calculated as 100/150 for Northland, and as 400/200 for Southland. But this is only because the production frontier assumes a linear trade-off. Marginal opportunity costs will vary with the level of production when trade-offs are non-linear, as is probably more likely in reality.
When Northland and Southland start trading, what is the negotiation space for the terms of trade?
The negotiation space for the terms of trade is the space between the two opportunity costs of production, as also depicted in the figure below. If the terms of trade are closer to 2:1, Northland becomes better off, because they would have been happy with 2/3:1.
Gain in the total number of units produced is higher in the example above than in the example provided in the lecture. Intuitively one may say that the example above is a more realistic representation of what will happen in reality, since the gain in number of units is higher.
Argue why this intuition is false.
The intuition is false because it is not the number of units that counts for welfare, it is utility attached to these units. Clearly preferences for and utility derived from clothes and food in Northland and Southland are different in the two examples, and without further information it is therefore difficult to assess in which example the increase in welfare from trade is higher.
