Suppose the world economy is composed of just two countries: Italy and Greece. Each can produce steel or chemicals, but at different levels of economic efficiency. The graphs show the production possibilities curves for the two countries.

If Italy and Greece should open up trade with each other, which of the following terms of trade is mutually beneficial?

Question

Suppose the world economy is composed of just two countries: Italy and Greece. Each can produce steel or chemicals, but at different levels of economic efficiency. The graphs show the production possibilities curves for the two countries.

If Italy and Greece should open up trade with each other, which of the following terms of trade is mutually beneficial?

BlackTom AI · Accepted Answer

Let's restate the problem in our own words and lay out what each option means in terms of the two countries' production possibilities.

- Italy’s PPF is linear with a slope of -1, so its opportunity cost of 1 ton of steel is 1 ton of chemicals (and equivalently, 1 chemical costs 1 ton of steel).
- Greece’s PPF is steeper or flatter depending on the scale, but from the diagram it shows 25 units of steel when 0 chemicals are produced and 0 steel when 60 chemicals are produced. This implies Greece’s opportunity cost of 1 ton of steel is 60/25 = 2.4 chemicals (i.e., to gain 1 additional ton of steel, Greece must give up 2.4 chemicals).

In a mutual trade, the terms of trade should lie between the two countries’ opportunity costs of producing steel in terms of chemicals. That is, the number of chemicals you trade for 1 ton of steel should be between 1 chemical per steel (Italy’s cost) and 2.4 chemicals per steel (Greece’s cost).

Now evaluate each option as a ratio of chemicals to steel (chemicals per 1 ton of steel):
- Option 1: 9 tons of chemicals = 5 tons of steel. This is 9/5 = 1.8 chemicals per steel, which lies between 1 and 2.4. This would be mutually beneficial.
- Option 2: 1 ton of chemicals = 1 ton of steel. This is 1/1 = 1 chemical per steel, exactly Italy’s opportunity cost; it could be mutually beneficial but offers no advantage beyond Italy’s alternative, effectively a boundary case.
- Option 3: 5 tons of chemicals = 2 tons of steel. This is 5/2 = 2.5 chemicals per steel, which is higher than Greece’s cost of 2.4 chemicals per steel; trading at this rate would not be beneficial for Greece (it would be paying more chemicals per steel than it could produce itself).
- Option 4: 2 tons of chemicals = 1 ton of steel. This is 2/1 = 2 chemicals per steel, which is between 1 and 2.4; this is also mutually beneficial.

From these analyses, options 1 and 4 both fall within the acceptable range of terms of trade and would be mutually beneficial. Option 3 clearly exceeds Greece’s opportunity cost, making it non-beneficial for Greece, and Option 2 sits exactly at Italy’s opportunity cost, a boundary case that provides no explicit margin for both sides.

Thus, options that meet the mutual gains condition are those with a chemicals-per-steel ratio between 1 and 2.4. In this question, the provided correct choice corresponds to the rate of 2 chemicals per 1 steel, i.e., 2 tons of chemicals = 1 ton of steel, which fits within the acceptable range and yields mutual gains for both countries.

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