A general rule of efficiency is that an individual or group should specialize in production activities in which it can operate more efficiently than other entities. This principle is referred to as comparative advantage when discussing international trade theory; it states that the worldwide production output is maximized when each country concentrates on producing goods for which it has lower opportunity costs.

In Figure 5.1, the U.S. is the low-cost producer for wheat, as it only gives up one unit of steel when it produces one unit of wheat. Great Britain is the high-cost producer for wheat, as it must give up two units of steel for each unit of wheat produced. However, Great Britain is the low cost producer for steel, as it gives up only one-half of a unit of wheat for each unit of steel produced. Therefore, the U.S. has a comparative advantage in producing wheat, while Great Britain has a comparative advantage in producing steel. According to the trade efficiency rule, the world will be better off if Great Britain specializes in steel production and the U.S. specializes in wheat production.

An easy way to determine which country has the comparative advantage is to compare the slopes of the production possibility curves. Suppose you have production possibility curves for two countries with product Y and X, and product Y is placed on the y-axis. The country with the most negative slope for product Y will have the comparative advantage with product Y.

Suppose each country specialized in producing the good for which it had a comparative advantage. The U.S. would produce 50 units of wheat per worker and Great Britain would produce 40 units of steel per worker. The combined world output would be 50 units of wheat and 40 units of steel. With no trade, the combined wheat output is 45 units and the combined steel output is 35 units. Clearly the two countries can benefit from trading with one another - the quantity of wheat produced goes up by five units and the quantity of steel produced goes up by five units. Trading offers more efficient production possibilities.
Terms of Trade

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

    Top 3 Steel Stocks of 2017

    Trump's plan to use U.S. steel for all new pipelines and pipeline repairs, positions these three steel stocks for gains.
  4. 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.
  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

    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.
  7. 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.
  8. Trading

    The 2016 Outlook for Wheat and Oat Futures

    Oats futures shows greater upside potential than wheat futures in 2016.
  9. Insights

    Is Now the Time to Buy Steel Dynamics? (STLD)

    After 15% declines over the past three months, it certainly seems as if the risk-versus-reward profile of Steel Dynamics has drastically improved.
Frequently Asked Questions
  1. Absolute P/E Ratio Vs. Relative P/E Ratio

    The difference between absolute P/E and relative P/E is easier when you know why each term is used.
  2. Why Do a Reverse Merger Instead of an IPO?

    Reverse mergers are often the most cost-efficient way for private companies to trade publicly.
  3. How Do Speculators Profit From Options?

    Options are a risky game, but you can learn speculators' tricks to use them to your advantage.
  4. What is the difference between a debenture and a bond?

    Debentures and bonds can both be used to raise capital, but debentures are typically issued to raise short-term capital.
Trading Center