CA Foundation · Business Economics · International Trade
Two countries, A and B, trade at a terms of trade ratio lying between their domestic opportunity cost ratios. Which of the following best explains why both countries gain from trade?
Both countries gain because each can obtain its imported good at a lower opportunity cost than by producing it at home. A terms of trade ratio between the two domestic cost ratios makes exchange more favourable than self-sufficiency for each side.
- AEach country can obtain the imported good at a lower opportunity cost than producing it domesticallyCorrect
- BEach country can export the same goods as the other country
- CEach country receives a tariff-free import quota from the other
- DEach country's absolute cost of production falls to zero
Explanation
When the trade price lies between the two domestic cost ratios, each country gets the good it imports more cheaply, in terms of foregone output, than by producing it at home. This is the source of mutual gains. The other options describe things that are not implied by the theory.
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