Problem:

The production possibilities tables for Malaysia and the United States are shown in the tables below. Before specialization and trade, Malaysia's optimal product mix is given by alternative C while optimal production in the U.S. is alternative J.

1. What is Malaysia's marginal opportunity cost of clothing? Of grain?
2. What is the U.S. marginal opportunity cost of clothing? Of grain?
3. Should these two countries specialize? If so, in what products should they specialize?
4. What is the total gain in production that could be achieved through specialization?
5. What are the limits on the terms of trade between the two nations?
6. Following specialization, suppose Malaysia exports 10 units of clothing to the U.S. in exchange for 10 units of grain. What are the gains from trade for each country?

Answer:

1. In Malaysia, 5 more units of clothing can be produced by giving up 3 units of grain. The opportunity cost of clothing is then 3/5 = 0.6 units of grain. The opportunity cost of grain is 5/3 = 1.67 units of clothing.
2. In the U.S., 8 additional units of clothing can be produced by giving up 10 units of grain. The opportunity cost of clothing is then 10/8 = 1.25 units of grain. The opportunity cost of grain is 8/10 = 0.8 units of clothing.
3. Malaysia has a lower opportunity cost of clothing while the U.S. has a lower opportunity cost of grain. Malaysia should specialize in clothing and the U.S. in grain.
4. Prior to specialization, the two countries' combined clothing production was 18 (10 in Malaysia and 8 in the U.S.). Total grain production was 36 (6 + 30). Following specialization, the U.S. will produce 40 units of grain (a gain of 4 units) and Malaysia 20 units of clothing (a gain of 2.)
5. The terms of trade can vary anywhere between the pre-trade opportunity cost ratios. That is, anywhere between 1 unit of clothing for 0.6 units of grain and 1 unit of clothing for 1.25 units of grain.
6. Following trade, Malaysia would have 10 units of clothing (production of 20 minus exports of 10) and 10 units of grain. Compared to its pre-trade choice at C, it has gained 4 units of grain. The U.S. would obtain 10 units of clothing and retain 30 units of grain (production of 40 minus its exports of 10.) This is a gain of 2 units of clothing compared to its pre-trade position.