Terms of Trade: Who Gains, and by How Much
- Distinguish output problems from input problems when computing opportunity cost
- Determine the range of mutually beneficial terms of trade
- Explain why absolute advantage is irrelevant to whether trade is beneficial
The output-vs-input trap
Comparative advantage questions come in two forms and the arithmetic inverts between them. In an output problem the table shows how much each country can produce with fixed resources — so opportunity cost is other good ÷ own good. In an input problem the table shows how many hours or workers each good requires — so opportunity cost is own good ÷ other good. The mnemonic that survives exam pressure is O-O-O: Output, Other over Own. Get this backward and every subsequent answer is wrong while looking perfectly reasoned, which is exactly why the exam keeps asking.
Absolute advantage is a distraction
Absolute advantage means producing more of a good with the same resources. Comparative advantage means producing it at a lower opportunity cost. Only the second determines who should specialize. A country can hold an absolute advantage in everything and still gain from trade, because it cannot hold a comparative advantage in everything — comparative advantage is a comparison of ratios, and if one ratio is lower the other must be higher. The exam tests this by describing a country that is better at both goods and asking whether trade helps. It does.
The range of acceptable terms
Specialization creates a surplus, but the terms of trade decide how it is split. A trade benefits both parties only when the exchange rate falls between the two countries' opportunity costs. If Country A gives up 2 units of wheat per car and Country B gives up 4, then any price between 2 and 4 wheat per car makes both better off — A receives more than the 2 wheat a car costs it, and B pays less than the 4 it would cost to build one. Outside that range one party would rather produce for itself, so no trade occurs.
With the same resources, Alpha can produce 20 tons of rice or 10 machines; Beta can produce 12 tons of rice or 12 machines. Find each country's comparative advantage and the range of mutually beneficial terms for one machine.
- 1.This is an OUTPUT table, so opportunity cost = other over own.
- 2.Alpha: 1 machine costs 20/10 = 2 tons of rice. 1 ton of rice costs 10/20 = 0.5 machines.
- 3.Beta: 1 machine costs 12/12 = 1 ton of rice. 1 ton of rice costs 1 machine.
- 4.Beta gives up less rice per machine (1 < 2), so Beta has the comparative advantage in machines; Alpha gives up fewer machines per ton (0.5 < 1), so Alpha has it in rice.
- 5.Beneficial terms for a machine lie strictly between Beta's cost of 1 ton and Alpha's cost of 2 tons.
Opportunity cost is per unit of the good you are pricing. "The opportunity cost of a machine" for Alpha is 2 tons of rice, not 20 tons — divide by the number of machines, not by one. Forgetting to normalize is the second most common error after inverting the ratio.
A table shows that Country X needs 4 labor hours per shirt and 2 labor hours per hat. What is Country X's opportunity cost of one shirt?
Country M can produce more of both goods than Country N using the same resources. It follows that:
Country P gives up 3 bushels of corn per tractor; Country Q gives up 6. Which terms of trade would both accept?
Write the two opportunity costs in a small table before answering anything, labeled with units ("1 machine = 2 rice"). Free-response rubrics award the opportunity-cost calculation separately from the conclusion, so a correct table earns points even if you then name the wrong country.
Answer the 3 checkpoints as you read.
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