Saturday, October 01, 2011

Terms of Trade

CFA Level 1 - Global Economic Analysis

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


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