Principles of Macroeconomics: Trade Theory

International trade is mutually beneficial because it allows countries to specialize in producing what they do best and import the rest.
Consider a world with two countries (US and the European Union) and two products A and B.
- A can be made more cheaply in the United States (it costs less units of labor).
- B can be made more cheaply in the EU.
World production is maximized if each country specializes in what they do best and then trade with each other.
Even if the US is better at producing both products A and B more cheaply than the European Union, it is still beneficial for the US to trade with the EU.
To understand why, we need to study the theory of comparative advantage.

If product A can be made more cheaply in the US and product B can be made more cheaply in the EU.
- US has an absolute advantage in producing A.
- EU has an absolute advantage in producing B.
Comparative advantage is defined in terms of opportunity costs.
Opportunity cost is the amount of one good that has to be given up in order to produce one more unit of the other good.
It is given by the slope of the production possibility frontier.
- The formula for opportunity cost involves ratios of production capabilities, effectively represented by the slope of the PPF.

Country A has a comparative advantage over country B in producing a product when the opportunity cost (in terms of production foregone of the other product) of production in country A is lower.
The slope of the production possibility frontier indicates the opportunity cost.
- How much of one good we need to give up in order to produce one more unit of the other good.
Let’s continue with our two-country example (United States and EU) – now let’s assume the two products are wheat and cloth.

Opportunity costs (how much of cloth production you need to sacrifice in order to produce one more unit of wheat)
United States:
- 1 kg wheat = 0.60 m cloth
- 1 m cloth = 1.67 kg wheat
European Union:
- 1 kg wheat = 2.00 m cloth
- 1 m cloth = 0.50 kg wheat

Changes from each producing one more unit of the product in which it has the lower opportunity cost.
United States (specializing in wheat):
- Wheat: +1.0
- Cloth: -0.6
European Union (specializing in cloth):
- Wheat: -0.5
- Cloth: +1.0
Total:
- Wheat: +0.5
- Cloth: +0.4

US has a comparative advantage in wheat production, and EU has a comparative advantage in cloth production.
If US specializes in wheat production and EU specializes in the production of cloth, then the combined output of wheat and cloth will be maximized.
Countries can then trade with each other to reach points above their production possibility frontier.
The gains from trade arise from differing opportunity costs in the two countries.
If opportunity costs were the same, there would be no comparative advantage and no gains from trade.

The difference in the slopes of the PPF’s reflect differences in comparative advantage.
If trade is possible at some terms of trade between the two countries opportunity costs of production, each country will specialize in the production of the good in which it has a comparative advantage. In each part of the figure, production occurs at U.
Consumption possibilities are given by the other (dotted) straight line – it has a slope equal to the terms of trade.
Consumption possibilities are increased in both countries; consumption may occur at some point such as d in each part. This involves a combination of wheat and cloth that was not obtainable by either country in the absence of trade.

Terms of trade are defined as the ratio between the index of export prices and the index of import prices.
If the export prices increase more than the import prices, a country has a positive terms of trade, as for the same amount of exports, it can purchase more imports.