Trade allows nations to specialize in the production of goods and services where they have a comparative advantage and then exchange them for goods they produce less efficiently. However, for trade to be mutually beneficial, the terms of trade must be fair and fall within an acceptable range based on the opportunity costs of each country. This section explains how to determine the range of acceptable terms of trade using opportunity cost data and provides step-by-step instructions with numerical examples.
UNDERSTANDING OPPORTUNITY COST IN TRADE
What Is Opportunity Cost?
In economics, opportunity cost refers to the value of the next-best alternative that is given up when a choice is made. In international trade, opportunity cost is measured in terms of how much of one good must be sacrificed to produce more of another good.
For example:
If a country can produce either 1 ton of wheat or 2 tons of steel, the opportunity cost of producing 1 ton of wheat is 2 tons of steel.
If another country can produce either 1 ton of wheat or 3 tons of steel, the opportunity cost of producing 1 ton of wheat is 3 tons of steel.
Each country has a different opportunity cost for producing goods, and trade is beneficial when each country specializes in producing the good for which it has the lowest opportunity cost and trades for the other.
Why Is Opportunity Cost Important for Trade?
Trade is only beneficial if the terms of trade allow both nations to get more of a good than they could produce on their own.
The terms of trade represent the rate at which one good is exchanged for another between countries.
If the terms of trade fall outside the opportunity cost range, one country will refuse to trade because it would be better off producing the good itself.
DETERMINING THE RANGE FOR MUTUALLY BENEFICIAL TRADE
For trade to be mutually beneficial, the terms of trade must satisfy the following condition:
The seller's opportunity cost must be less than the terms of trade (so the seller benefits).
The buyer's opportunity cost must be greater than the terms of trade (so the buyer benefits).
If the terms of trade fall outside this range, one country will lose more than it gains and will not participate in trade.
STEP-BY-STEP GUIDE TO CALCULATING MUTUALLY BENEFICIAL TERMS OF TRADE
STEP 1: DETERMINE OPPORTUNITY COSTS FOR EACH COUNTRY
To calculate the range of mutually beneficial terms of trade, start by identifying the opportunity cost for each country. This is done by comparing how much of one good must be given up to produce another.
Example Scenario
Suppose Country A and Country B both produce wheat and cloth, but with different levels of efficiency. Their production possibilities are:
Country A: 1 unit of wheat = 2 units of cloth
Opportunity cost of producing 1 wheat = 2 cloth
Country B: 1 unit of wheat = 3 units of cloth
Opportunity cost of producing 1 wheat = 3 cloth
STEP 2: ESTABLISH THE RANGE FOR MUTUALLY BENEFICIAL TRADE
To ensure that both countries benefit from trade, the exchange rate of wheat for cloth must fall between the two opportunity costs.
Lower bound: Country A's opportunity cost of wheat (2 cloth per wheat)
Upper bound: Country B's opportunity cost of wheat (3 cloth per wheat)
This means that for trade to be beneficial, the terms of trade must be:
2 cloth per wheat < 1 wheat < 3 cloth per wheat
Any trade agreement that falls within this range ensures that both countries are better off trading than producing everything on their own.
STEP 3: SELECTING A POSSIBLE TRADE RATIO
Any exchange rate that falls between the opportunity costs will allow both countries to gain from trade. Possible terms of trade might be:
1 wheat for 2.5 cloth (between 2 and 3 cloth)
1 wheat for 2.8 cloth (also within range)
If the terms were 1 wheat for 1.5 cloth, Country A would not trade because it can already get 2 cloth per wheat on its own.
If the terms were 1 wheat for 3.5 cloth, Country B would not trade because it only gives up 3 cloth per wheat when producing wheat itself.
STEP 4: VERIFYING GAINS FROM TRADE
After selecting a trade ratio, check if both countries gain:
Country A: If it trades 1 wheat for 2.5 cloth, it gains 0.5 cloth per wheat compared to its opportunity cost.
Country B: If it trades 2.5 cloth for 1 wheat, it saves 0.5 cloth per wheat compared to producing wheat itself.
Since both countries benefit, these terms of trade are mutually beneficial.
APPLYING MUTUALLY BENEFICIAL TERMS OF TRADE TO DIFFERENT SCENARIOS
CASE 1: DIFFERENT GOODS, DIFFERENT PRODUCTION RATES
If two countries produce different goods at different rates, the range of beneficial terms of trade is still determined by opportunity costs.
For example:
Country X: 1 car = 5 tons of steel
Country Y: 1 car = 8 tons of steel
The mutually beneficial terms of trade would be:
5 tons of steel < 1 car < 8 tons of steel
If the terms of trade were 1 car for 9 tons of steel, Country Y would refuse to trade.
If the terms were 1 car for 4 tons of steel, Country X would refuse to trade.
CASE 2: WHEN A COUNTRY HAS AN ABSOLUTE ADVANTAGE IN BOTH GOODS
A country may have an absolute advantage in producing both goods, meaning it produces them more efficiently than another country. However, comparative advantage still determines trade.
For instance:
Country C can produce 1 laptop for 3 smartphones.
Country D can produce 1 laptop for 5 smartphones.
Country C should specialize in laptops, and Country D should specialize in smartphones. The terms of trade must be between:
3 smartphones per laptop < 1 laptop < 5 smartphones per laptop
A trade agreement at 1 laptop for 4 smartphones would benefit both.
FAQ
The terms of trade must fall between the opportunity costs of both countries to ensure that trade is mutually beneficial. If the terms of trade exceed a country’s opportunity cost, it would be better off producing the good itself rather than trading. Similarly, if the terms of trade are lower than the opportunity cost of the other country, that country would not be willing to trade, as it would be losing more than it gains.
For example, if one country gives up 2 units of cloth per unit of wheat and another country gives up 3 units of cloth per unit of wheat, then trade will only occur if the terms of trade fall between 2 and 3 units of cloth per unit of wheat. If the trade ratio is below 2 cloth per wheat, the first country will not export wheat. If the trade ratio is above 3 cloth per wheat, the second country will not import wheat. Staying within the opportunity cost range ensures that both nations receive a good at a lower cost than if they produced it themselves, making trade worthwhile.
Improvements in production technology can shift opportunity costs, thereby altering the range of mutually beneficial terms of trade. If a country becomes more efficient at producing a good, it will require fewer resources to produce it, which can lower the opportunity cost of that good. This change can expand or shrink the acceptable range for trade, depending on how opportunity costs shift in each country.
For instance, if a country initially sacrifices 4 tons of steel per car but then develops new manufacturing techniques that reduce this to 2 tons of steel per car, its opportunity cost of producing cars has decreased. This would lower the lower bound of acceptable trade terms for cars. The other country, however, may still be willing to trade if it is sacrificing 6 tons of steel per car. Now, the range for mutually beneficial trade would be between 2 and 6 tons of steel per car, compared to the previous range of 4 to 6 tons.
As technology evolves, the opportunity cost for goods changes, potentially making some trades less attractive while making others more favorable. If one country’s production efficiency improves dramatically, it may no longer need to trade because it can produce all goods at a lower opportunity cost than its trading partners.
Government policies, particularly tariffs and subsidies, can distort mutually beneficial terms of trade by artificially altering opportunity costs and incentives for trade.
A tariff is a tax on imports that makes foreign goods more expensive. When a country imposes tariffs on an imported good, it raises the effective cost of trading, which may push the terms of trade outside the mutually beneficial range. If the cost of importing a good exceeds the domestic opportunity cost of producing it, the country may choose not to trade at all, reducing economic efficiency.
Subsidies, on the other hand, lower production costs for domestic industries by providing financial support. If a government heavily subsidizes an industry, it can lower the domestic opportunity cost of production, shifting the acceptable range of trade terms. This can give domestic producers an unfair advantage, making trade less attractive for foreign partners.
For example, if a country subsidizes wheat production, its domestic producers might accept a much lower trade ratio, making foreign wheat less competitive. Similarly, if an importing country imposes high tariffs on wheat, it reduces the incentive for international trade, even if both nations would benefit under normal conditions. These trade policies can result in trade imbalances, retaliatory tariffs, and less efficient resource allocation.
Economic growth affects comparative advantage and mutually beneficial terms of trade by changing a country’s productivity, resources, and opportunity costs. When a country experiences economic growth, it can produce goods more efficiently, shifting its comparative advantage and altering the terms of trade.
If a country develops new capital resources, such as better factories, advanced technology, or a more skilled workforce, it may reduce the opportunity cost of producing certain goods. As a result, the country may become more competitive in global markets, shifting its focus to goods where it now has a greater comparative advantage. This can expand the range of beneficial trade terms by allowing it to trade under more favorable conditions.
However, if a country’s economic growth is concentrated in one sector, it may lose comparative advantage in other industries. For example, if Country X experiences rapid growth in automobile production but stagnates in food production, it may become more reliant on importing food. This change can affect how it negotiates trade deals and shift its terms of trade accordingly.
Additionally, growth in one country can impact global trade dynamics. If a large economy like China or the United States experiences significant productivity growth, it can drive down global prices for certain goods, forcing other nations to adjust their terms of trade. Countries that fail to keep up with technological advancements may find themselves in less favorable trade positions over time.
If two countries have identical opportunity costs for producing all goods, then there is no comparative advantage, meaning trade would not provide any additional benefits. Comparative advantage is the foundation of mutually beneficial trade, allowing each country to specialize in producing goods at a lower opportunity cost. Without a difference in opportunity costs, neither country gains from specialization, and trade becomes unnecessary.
For example, if Country A and Country B can each produce 1 unit of wheat for 2 units of cloth, and 1 unit of cloth for 0.5 units of wheat, their opportunity costs are identical. In this scenario, trading 1 wheat for 2 cloth or 1 cloth for 0.5 wheat does not offer any benefits that couldn’t be obtained by simply producing the goods domestically. Since both countries can produce the same amounts at the same cost, they would have no incentive to trade.
In reality, perfect equality in opportunity costs is extremely rare due to differences in resources, labor productivity, and technological capabilities. However, if countries have nearly identical opportunity costs, trade may be minimal or only driven by non-economic factors, such as geopolitical alliances, supply chain diversification, or consumer preferences.
Practice Questions
Assume two countries, Country A and Country B, both produce only wheat and cloth. The opportunity cost of producing one unit of wheat in Country A is 2 units of cloth, while in Country B, the opportunity cost of producing one unit of wheat is 3 units of cloth. What is the range of mutually beneficial terms of trade for one unit of wheat? Explain why trade within this range benefits both countries.
The mutually beneficial terms of trade for one unit of wheat must be between 2 and 3 units of cloth. Country A will only trade wheat if it can receive more than 2 cloth per wheat, as that is its opportunity cost. Country B will only accept trade if it gives up less than 3 cloth per wheat, as that is its opportunity cost. If the agreed terms of trade are between 2 and 3 cloth per wheat, both countries benefit because they obtain wheat or cloth at a lower opportunity cost than producing it domestically.
Suppose two nations, Country X and Country Y, produce only cars and steel. Country X can produce one car by sacrificing 4 tons of steel, while Country Y can produce one car by sacrificing 6 tons of steel. If these countries engage in trade, what are the acceptable terms of trade for one car? Justify your response using opportunity cost.
The mutually beneficial terms of trade for one car must be between 4 and 6 tons of steel. Country X will only export a car if it receives more than 4 tons of steel in return, as this is its opportunity cost. Country Y will only accept a trade if it gives up less than 6 tons of steel per car, as that is its opportunity cost. If the terms of trade fall within this range, both nations benefit. Country X gains more steel per car than it could domestically, while Country Y obtains cars at a lower cost than producing them itself.
