Global Economic Analysis - Terms of Trade

The next question to determine is what the terms of trade would be. Clearly the U.S. will not accept less than one unit of steel per unit of wheat, as that is the cost if no trade occurs. Also, we know that Great Britain will not accept less than one-half of a unit of wheat for its steel, as that is the cost tradeoff without trade.

The actual terms of trade would need to lie somewhere in between these limits. Suppose Great Britain offered five units of wheat for each five units of U.S. steel. The U.S. would not accept such an offer for its steel production because five units of steel could be traded for five units of wheat internally.

The actual terms of trade will depend on overall world and supply conditions, within the limits just mentioned. However, trade will not occur unless the trade is mutually beneficial.

Suppose the terms of trade settle at 1.5 units of steel per unit of wheat. We can graph a trading possibilities curve and relate that curve to the original production possibilities curve.

Figure 5.2: Trading Possibilities Curve

The slope of the trading possibilities curve will be -1.5 for each country. The original production possibilities curve is shifted to the trading possibilities curve by specializing in the production of the good for which each country has a comparative advantage and by then engaging in international trade. As the possible amount of consumption increases for both countries, they will each enjoy a higher standard of living.

Recall that we assume that without trade, the U.S. will consume 35 units of wheat and 15 units of steel for the U.S and that Great Britain will consume ten units of wheat and 20 units of steel. These points are shown as Point A in both of the graphs above. With the trading possibilities at -1.5, the U.S. could specialize in wheat production and then trade 12 units of wheat for 18 units of steel. The country would then end up with 18 units of steel, and keep 38 units of its own wheat production. This point is described as Point B in the U.S. graph above. Great Britain could benefit in a similar manner.

Note that the above analysis assumes that relative production costs are constant, which allows for straight lines to be used as a production possibilities curve. In reality, as more and more of a good is produced, relative production costs increase because less efficient resources will be used as production increases. As a result, we expect that production possibility curves will be curved lines. Therefore, specialization will not be an all-or-nothing type of situation. Even if the U.S. is a relatively inefficient producer of steel, some steel production will still occur in the United States. Similarly, while Great Britain will mostly be producing steel, some wheat production will still occur in Great Britain.

Domestic producers of goods that are produced relatively cheaply will be able to get higher prices in the world market. Suppose the U.S. is a relatively efficient producer of wheat. In the Figure 5.3 below, the quantity demanded and the quantity supplied would be equal at domestic price Pdw. However, U.S. wheat producers would prefer to export their goods at the world price Pww. By doing so, they will achieve higher profits. Consumers will lose out because they will have to pay higher world prices.

Figure 5.3: Effects of International Trade on Domestic Supply and Demand

However, for goods produced relatively inefficiently by the U.S., consumers will benefit by paying lower prices. Using shirts as an example, we can see that without international trade, consumers would pay price Pds for shirts. By allowing imports, consumers can pay the lower price Pws. Producers are hurt because they will have to take the lower world price.

Figure 5.4: Effects of International Trade on Domestic Supply and Demand

Tariffs and Quotas
Related Articles
  1. Personal Finance

    Invest in Costco? First Understand Its Balance Sheet

    A strong balance sheet sets a company apart and boosts investor confidence. How healthy is Costco based on an analysis of its balance sheets from the last two years?
  2. Investing Basics

    Brokers and RIAs: One and the Same?

    Brokers and registered investment advisors have some key differences. Here's what you need to know.
  3. Professionals

    DCF Vs. Comparables: Which One To Use

    DCF and Comparables models are widely used in equity valuation. We explain the pros and cons of each method.
  4. Professionals

    How To Make Money Using Tobin's Q Ratio

    Although it seems simple, Tobin's Q Ratio is more complex than it appears. We explore some of its main strengths and weaknesses.
  5. Taxes

    3 Secrets You Didn't Know About Estate Planning

    Every advisor and saver needs to know these three estate planning secrets.
  6. Professionals

    Cash Flow Is King: How to Keep it Running

    Why is cash flow so important, and what steps can a business take to improve it?
  7. Entrepreneurship

    10 Ways to Nurse Cash Flow in Healthcare

    Running a business in healthcare? You might want to rethink cash flow management practices.
  8. Professionals

    How to Help Clients with Cash Flow Issues

    Sometimes your spending gets out of hand or income has a hiccup. Here's how financial advisors can help clients who have cash flow issues.
  9. Professionals

    How to Improve Your Cash Flow in Manufacturing

    Here are 10 ways to to improve a manufacturer's cash flow.
  10. Professionals

    10 Ways to Improve Cash Flow in Construction

    Improving cash flow in construction requires some sector-specific strategies.
RELATED TERMS
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  4. Security Analyst

    A financial professional who studies various industries and companies, ...
RELATED FAQS
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!