We want to maximize the utility subject to the PPF:

2 2
0 ,5 0 ,5 Y X
L= X Y − λ( + −1)
196 64
−0 ,5 0, 5 λ
L X =0 , 5 X Y − X=0
32
0 ,5 −0 , 5 λ
LY =0 , 5 X Y − Y =0
98
Dividing both equation:

−0 ,5 λ 0 ,5
0 ,5 X XY −
32
=0
0 , 5 −0 ,5 λ
0,5 X Y − Y
98
 λ
−0 ,5 X
0 ,5
0 ,5 X Y 32
=
0 ,5 −0 ,5
0 ,5 X Y λ
Y
98
X
Y 32
=
X Y
98
Y 98 X
=
X 32 Y
2 2
32 Y =98 X
2 98 2
Y = X
32
7
Y= X
4
Inserting into the constraint:
2 2
Y X
+ =1
196 64

( )
2
7
X 2
4 X
+ =1
196 64
49 2
∗X 2
16 X
+ =1
196 64
49
16 1
X2( + )=1
196 64

X2 ( 16∗196
49
+ )=1
1
64

2 1
X =
49 1
+
16∗196 64

√
1
X= =4 · √ 2
49 1
+
16∗196 64
 7 7
Y= X= · 4 · √ 2=7 · √ 2
4 4
We know, that we can find the MRS as the relative slope of the indifference curve. Due to the fact that we
have optimized, this is equal to the price ratio in Autarky.

MRS=
∂
∂X
=
√
1
U ( X , Y ) 2 X √Y
⋆ ⋆
| ⋆
X ,Y ·
∂
∂Y
U ( X ,Y )
⋆ ⋆ 1
2 √Y
√X | ⋆
X ,Y
·

1
√ 7 √2
2 √4 √2
MRS=
1
√ 4 √2
2 √7 √ 2

( )
px
p y America
4
=MRS= =1.75
7

Same way to calculate the relative price in Europe:

( )px
py Europe
=MRS=1.2

( )
px
py America
4
=MRS= =1.75
7

( ) px
py Europe
=MRS=1.2

America has a higher opportunity cost in terms of X. Therefore America will produce Y and Europe will
produce X. The intuition is that Europe only has to give up 1.2 units of Y to produce X. This is cheaper than
America whereas Europe will specialize in X.