Trade Specialization and Gain

Question:

Which of the following prices of trade (that is, the price of wine in terms of oil) would allow both Switzerland and Italy to gain from trade?

a. 4 barrels of oil per bottle of wine
b. 1 barrel of oil per bottle of wine
c. 7 barrels of oil per bottle of wine
d. 2 barrels of oil per bottle of wine

Answer:

All except '7 Barrels of oil per bottle of wine'

Italy and Switzerland can gain from specialization and trade as long as they receive more than 1/5 barrel of oil for each bottle of wine they export to each other. This means that they need to get a favorable ratio of oil to wine in order to benefit from the trade.

For example, '4 Units Oil = 1 Unit Wine' implies '1 unit oil = 1/5 i.e 0.25 units Wine'. This ratio is favorable for both Switzerland and Italy as they both get more than 1/5 or 0.20 units oil per unit wine and more than 1/5 or 0.20 units wine per unit oil. Similarly, '1 Unit Oil = 1 Unit Wine' is also a favorable term of trade for both countries as it satisfies the condition of getting more than 1/5 or 0.20 units of oil per unit of wine and vice versa.

On the other hand, '7 units oil per unit wine' would be favorable for Italy as it receives more than 1/5 or 0.20 units of oil per unit of wine. However, it is not favorable for Switzerland as it gets 1/7 = 0.14 units of wine per unit of oil, which is less than 1/5 or 0.20 units of wine per unit of oil. Therefore, this price would not benefit both countries in the trade agreement.