To illustrate the benefits of trade, we should look at the production possibility curves for two nations, Great Britain and the U.S. The production possibility curve (or production possibility frontier) shows the maximum possible output of an economy. To simplify things, we will assume that only two goods are produced - wheat and steel.

Figure 5.1: Production Possibility Curves

According to the production possibilities curve shown in the above graphs, the U.S. could produce 50 units of wheat per worker, if it devoted all of its resources to wheat production, and zero units of steel. If all resources were devoted to producing steel, then the U.S. would have 50 units of steel per worker and no wheat. If Great Britain devotes all of its resources to making wheat, it can produce 20 units of wheat, with no steel being produced. If that country concentrates all of its resources on producing steel, then 40 units of steel would be produced per worker, with no wheat production. Please note that the U.S. has an absolute advantage over Great Britain with both products because the U.S. workers are more productive than those from Great Britain. However, this is not important from an international trade perspective.

The domestic exchange rate within the U.S. for the two goods is 1:1; for each unit of steel produced, the U.S. must give up producing one unit of wheat. We could say that the cost of one unit of steel within the U.S., assuming no international trade, would be one unit of wheat. Similarly, the cost of one unit of wheat would be the loss of one unit of steel.

Great Britain would have a different domestic exchange rate. Its production possibility curve implies that the cost of one unit of steel would be one-half of a unit of wheat. The cost of one unit of wheat would be two units of steel. These costs can be obtained by looking at the slope of the production possibility curve.

If the U.S. and Great Britain both operated as autarkies (self-sufficient nations that do not trade), then each country would operate somewhere on their production possibilities curve. The exact point of production would depend on each country's supply and demand for the goods. For example, these points could be 35 units of wheat and 15 units of steel for the U.S., and 10 units of wheat and 20 units of steel for Great Britain, as illustrated in Figure 5.1.

Trade Efficiency Rule

Related Articles
  1. Investing

    Can U.S. Steel Stock Really Climb 50% in One Year? (X)

    United States Steel comes highly recommended for risk-tolerant investors, according to Barron's.
  2. Investing

    Top 4 Steel Stocks of 2017

    Trump's plan to use US Steel for all new and pipelines and pipeline repairs position these four steel stocks to break out soon and have a stellar 2017.
  3. Investing

    Are There Still More Gains For Steel Stocks Ahead?

    The steel sector has rebounded quite nicely over the last few months as investors have looked for value. Given the longer term demand picture, the value is still there and more gains could still ...
  4. Insights

    U.S. Raises China Steel Import Duty Sixfold (SLX)

    The U.S. said Tuesday it would raise import duties on Chinese cold-rolled steel by 522%.
  5. Investing

    Assessing United States Steel's Valuation (X)

    With shares of United States Steel skyrocketing 101% year-to-date, it's safe to say "X" has marked the right spot for many portfolios.
  6. Investing

    Why AK Steel Stock Surged 32% Last Week (AKS, SLX)

    Steel manufacturers posted strong gains last week in the wake of Donald Trump's surprise victory for the White House.
  7. Investing

    AK Steel Stock Get Downgraded by Jefferies (AKS)

    One would need fortitude as strong as steel to invest in steel stocks over the past month.
  8. Investing

    U.S. Steel Earnings Coming Up, What to Expect (X)

    U.S. Steel comes highly recommended, according to Barron's, which expects the stock to reach $37 per share in 12 months.
  9. Insights

    U.S. Steel 'Very Undervalued': Credit Suisse (X)

    The risk-versus-reward profile of United States Steel continues to be a hot topic for investors.
  10. Investing

    Steel Cycle Looks Good

    Buying cyclical stocks at the right time can be a great investment strategy, but it requires more than just trying to time a cycle to benefit.
Frequently Asked Questions
  1. What's the Best Way to Contact Warren Buffett?

    Learn how to contact Warren Buffett and what kinds of contact is most likely to receive a response from him or from his company, ...
  2. What is the Financial Services Sector?

    A diverse group of companies, beyond banks and credit unions, comprises the financial services sector.
  3. Who are Whole Foods' (WFM) main competitors?

    Whole Foods' main competitors are Sprouts Farmers Markets and Trader Joe's. However, the recent acquisition by Amazon my ...
  4. What caused the Stock Market Crash of 1929 that preceded the Great Depression?

    Find out what led to the stock market crash of 1929, which in turn led to the Great Depression. It sparked a nearly 90% loss ...
Trading Center