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. Career Education & Resources

    How Hard are the CFA Exams?

    Learn about the difficulty of the CFA exams with a description of the tests, some statistics on pass rates and suggestions that can help you pass the exams.
  2. Professionals

    What it Takes to be a Financial Analyst

    A financial analyst researches companies and economic conditions to make business, sector and industry recommendations.
  3. Career Education & Resources

    Financial Analyst: Career Path & Qualifications

    Read about what it takes to become a financial analyst in a corporation or securities firm, and learn how far you can rise in the profession.
  4. Career Education & Resources

    Financial Planner: Career Path & Qualifications

    Learn what education and certifications you need to become a financial planner, as well as the future prospects and earnings potential for financial planners.
  5. Career Education & Resources

    Where to Find Non-Profit Finance Jobs

    The non-profit sector offers a stable selection of jobs for those who seek other types of fulfillment from their jobs than just purely financial.
  6. Career Education & Resources

    Portfolio Manager: Career Path & Qualifications

    Learn about the basic requirements for getting hired as a portfolio manager, and discover how most professionals in the field rise into the position.
  7. Your Practice

    4 Professional Associations Advisors Should Join

    These four professional organizations are among the most respected and well known in the industry.
  8. Professionals

    Equity Research: Career Path and Qualifications

    Find out what equity research analysts do on a day-to-day basis, and learn more about the typical career progression for these securities professionals.
  9. Professionals

    What's on the CFA Level II Exam?

    The Chartered Financial Analyst Level II exam is the second of three tests that CFA candidates must pass.
  10. Professionals

    Financial Data Analyst: Career Path & Qualifications

    Learn more about the career options available to financial data analysts, and determine whether the profession is a good match for you.
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 >>
Hot Definitions
  1. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  2. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  3. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  4. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  5. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
Trading Center