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

    How China Impacts the Global Steel Industry

    The Chinese economy is having a significant impact on the performance and profitability of steel and mining stocks.
  2. 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.
  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

    Trump's Wall Could Be Great News for Steel Stocks

    So Trump signed the order for the Wall. Some industries stand to gain. A lot.
  6. Investing

    Is Now The Time To Invest In Steel?

    Recent price drops present long-term opportunities, while many stable ETFs remain attractive. Learn your best options for turning cold hard steel into cold hard cash.
  7. Investing

    Steel Stocks Reach 52-Week Highs on Trump Rally (AKS, NUE)

    Several steel manufacturers soared to 52-week highs on Tuesday, as did the Market Vectors Steel ETF.
  8. 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.
  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.
Frequently Asked Questions
  1. Does the S&P 500 index include dividends?

    Learn about dividend payments and the S&P 500, as well as how the yield has trended lower over time due to changes in ...
  2. What are the best ways for a company to improve its net margin?

    Learn about what businesses can do to increase their net margin, including ways to increase sales revenue and decrease operational ...
  3. What is the difference between a 401(a) and a 401(k)?

    Learn about 401(k) plans and 401(a) plans, and discover the key differences between these two types of retirement plans, ...
  4. What's the difference between a 401(k) and a Roth IRA?

    A 401(k) and a Roth IRA differ primarily on tax treatment, investment options, employer involvement, and limitations on contributions ...
Trading Center