How does the decentralized world market induce efficient allocation of production of cheese

and wine?

- Let us just focus on cheese first

- Think of each country as a machine that can turn wine into cheese
- Therefore, you can think of wine being used to make cheese in this machine
- Efficiency means that the country with lower opportunity cost of producing cheese
(i.e. uses less wine to produce each unit of cheese) in fact produces cheese
- In a decentralized global market, cheese is sold at the same price, regardless of where
it is produced (and so is wine).
- Therefore, if cheese produced with higher opportunity cost (say from country A) is
sold in the market, then cheese produced with a lower opportunity cost (say from
country B) must be sold as well. This will be the situation when the relative price of
cheese is very high.
- But the two countries cannot both sell cheese in equilibrium, as this would not satisfy
consumers, who demand both cheese and wine
- Therefore, in equilibrium, only the country with lower opportunity cost in producing
cheese will sell cheese. This will be the situation when the relative price of cheese is
sufficiently high to induce the country with low opportunity cost to sell but not so
high as to induce the country with high opportunity cost to sell it.
- Thus, the market allocates the production of cheese to country B, which is efficient.
- The argument applies to wine as well