In your answer to this question, use a diagram like Figure 4.3 and start from a no-trade point

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QUESTION:

In your answer to this question, use a diagram like a Figure 4.3 and start from a no-trade point like S0 with a no-trade price ratio of 2 W/C. Now trade is opened and the country can trade whatever it wants at an international price ratio of 1 W/C. (In your answers, you will need to picture additional community indifference curves that exist but are not shown explicitly in Figure 4.3.)

Figure 4.3: Indifference Curves and Production Possibilities without Trade

Without trade, the best an economy can do is to move to the production point that touches the highest community indifference curve. This best no-trade point is S0. where the nation both produces and consumes, reaching indifference curve I1.

a. Show that the country can gain from trade even if the country does not change its production point. (Production stays at point S0.) (The price line with a slope of 1 will go through point S0 but will not be tangent to the production-possibility curve.)

b. Show that the country can gain even more from trade if it also adjusts the production point to its optimal position (given the price ratio of 1).

c. What happens to the volume of trade as the country’s position shifts from that shown in part a to that shown in part b?


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