Suppose that the cost of producing 1 unit of wine in Happy Island is 2 units of rice;in Joy Island 1 wine costs 4 rice.What might be possible terms of trade between the two countries?

Question

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To find the possible terms of trade, we need to compare the opportunity cost of each country's production. Happy Island can produce 1 unit of wine for 2 units of rice, which means the opportunity cost of producing 1 unit of wine is 2 units of rice. Joy Island can produce 1 unit of wine for 4 units of rice, which means the opportunity cost of producing 1 unit of wine is 4 units of rice.

Therefore, Happy Island has a lower opportunity cost of producing wine than Joy Island. In other words, Happy Island has a comparative advantage in producing wine. Joy Island has a comparative advantage in producing rice.

To establish beneficial terms of trade, the exchange rate should lie between the opportunity costs of each country's production. In this case, the exchange rate should be between 2 rice per wine and 4 rice per wine.

Since Joy Island has a higher opportunity cost of wine production, they would be willing to trade wine at a lower price than Happy Island. Happy Island should accept as long as the price is higher than their opportunity cost. The only option that lies between the two opportunity costs is A: 1 rice = 3/8 wine. Therefore, the possible terms of trade between Happy Island and Joy Island could be 1 rice for 3/8 wine.

Suppose That the Cost of Producing 1 Unit of Wine