Counties A and B currently consume 400 units of food and 400 units of textiles each and currently do not trade with one another.The citizens of country A have to give up one unit of food to gain two units of textiles,while the citizens of country B have to give up one unit of textiles to gain two units of food.Their production possibilities curves are shown. Under the theory of comparative advantage,if free trade is allowed,the market clearing price (or exchange rate,if you will)between food and textiles will be
A)one unit of food for one unit of textiles.
B)somewhere between one unit of food for two units of textiles and two units of food for one unit of textiles.
C)one unit of food for two units of textiles.
D)two units of food for one unit of textiles.

Question

Counties A and B currently consume 400 units of food and 400 units of textiles each and currently do not trade with one another.The citizens of country A have to give up one unit of food to gain two units of textiles,while the citizens of country B have to give up one unit of textiles to gain two units of food.Their production possibilities curves are shown.  Under the theory of comparative advantage,if free trade is allowed,the market clearing price (or exchange rate,if you will)between food and textiles will be
A)one unit of food for one unit of textiles. 
B)somewhere between one unit of food for two units of textiles and two units of food for one unit of textiles. 
C)one unit of food for two units of textiles. 
D)two units of food for one unit of textiles.

Quizplus · Accepted Answer

If there is free trade between these two countries, it would be beneficial for both countries to produce and export the goods in which they have a comparative advantage. From the production possibility curves, we can see that country A has a comparative advantage in producing textiles (it has a lower opportunity cost of producing textiles) while country B has a comparative advantage in producing food.

If country A produces more textiles and trades with country B, it can obtain more food at a lower cost than producing food on its own. Similarly, if country B produces more food and trades with country A, it can obtain more textiles at a lower cost than producing textiles on its own. As a result, the exchange rate will lie somewhere between the two opportunity costs of producing each product, which is one unit of food for two units of textiles and two units of food for one unit of textiles. Thus, the answer is B) somewhere between one unit of food for two units of textiles and two units of food for one unit of textiles.

Counties a and B Currently Consume 400 Units of Food