Terms of trade

Terms of TradeBy Mike Fladlien

IntroductionAfter teachers demonstrate comparative advantage, they usually show how comparative advantage and specialization leads to gains for both trading profits. The instructor will say something like “Suppose that 12 apples are traded for 8 loaves of bread.”

Then the instructor will draw a trading possibilities curve that is above the production possibilities curve. This curve shows that both partners gain by trade. This demonstration always begs the question, “How do you know what the terms are?”

Introduction

This tutorial is meant to give ample instruction to motivated teacher on how to calculate terms of trade, justify the terms in a way that are acceptable and understandable to students, reliably and confidently derive the terms quickly to earn that one point, and to extend the knowledge of student study of comparative advantage at a level of allows a deeper analysis of trade.

Example 1

This example comes from Roger A. Arnold, pages 36 – 37, Trading Without Money. The text begins with a table showing production possibilities that are shown are follows.

There are several steps to determine the terms of trade that can be learned and applied quickly to a problem. These steps are:

(1) graph the Production Possibilities Curves for both traders;

(2) determine the comparative advantage;

(3) reduce the opportunity cost to units of 1;

(4) make a vector graph that plots the opportunity cost;

(5) find a point on the vector graph;

(6) graph the trading possibilities curve.

Step 1Graph the Production Possibilities Curves for Both Partners

Step 2Determine the Comparative Advantage

Step 3Step 3 Reduce the opportunity cost into a per-unit costBrian

1A = 1/3B1B = 3A

Liz1A = 1B1B = 1A

Step 4Plot a Vector Graph And Find A Point Between

This graph shows that at a trade of 12A:8B Brian pays less for bread and Liz gets more than 1 loaf of bread for 1 apple. The intuition is that this is a mutually beneficial trade. Note that between the two vectors there are an infinite number of trades.

Step 5Plot the Production Possibilities Curve

Example 2This example comes from Krugman-Wells.

Let’s begin with the graph of the Production Possibilities Curve.

Steps 2 and 3 Determine the Comparative Advantage and Per-Unit Cost

Reduce the opportunity cost to one to make comparison easier.

Step 4Make a vector graph

Conclusion

I think one could just draw the PPFs then choose a point outside the PPFs and this would be acceptable terms of trade. One would have to be careful not to trade so much away that the country would fall below its autarky point.

I hope the reader who invested enough time into this paper will have gained enough to either calculate

the terms of trade or be able to answer if an exchange is a feasible terms of trade on the AP Micro/Macro exam.

I used to read that a country would trade up to its opportunity cost. I now understand what that means and I hope that you do too.