Suppose Big Country can produce 80 units of X by using all its resources to produce X or 60 units of Y by devoting all its resources to Y. Comparable figures for Small Nation are 60 units of X and 60 units of Y. Assuming constant costs, in which product should each nation specialize? Explain why. What are the limits of the terms of trade between these two countries?

The opportunity cost of producing X good is calculated below:

$$\begin{gathered} Bigcountry=\frac{60}{80} \\ =0.75Y \\ SmallNation=\frac{60}{60} \\ =1Y \end{gathered}$$

The opportunity cost of producing Y good is calculated below:

$$\begin{gathered} BigCountry=\frac{80}{60} \\ =1.33X \\ SmallNation=\frac{60}{60} \\ =1X \end{gathered}$$

As the opportunity cost of production is less for X in Big Country than Small Nation, the latter has a lower opportunity cost for Y than Big Country; hence, Big Country should produce X, and Small Nation should produce Y.

Terms of trade are the exchange ratio for the X and Y. Big Country will never agree to pay more than 1.33 units of good X for a unit good Y; then, it can produce itself. Small Nation will not accept less than 1 unit of good X for a unit of good Y, as it can produce either good X or good Y. The limit for terms of trade will be in between 1 unit of good X for 1 unit of good Y and 1.33 units of good X for 1 unit of good Y.