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C H A P T E R 2

Exploring Further 2.1

Comparative Advantage in Money Terms

To illustrate comparative advantage in money terms, refer to the comparative-advantage exampleof Table 2.3 (pp. 35 of International Economics,13th edition) that assumes that labor is the only input and is homogeneous. Recall that (1) theUnited States has an absolute advantage in theproduction of both cloth and wine; and (2) theUnited States has a comparative advantage incloth production, while the United Kingdom hasa comparative advantage in wine production. This

information is restated in Table EF 2.1. As we shallsee, even though the United Kingdom is absolutely less efficient in producing both goods, it willexport wine (the product of its comparative advan-tage) when its money wages are so much lowerthan those of the United States that it is cheaperto make wine in the United Kingdom. Let’s seehow this works.

Suppose the wage rate is $20 per hour in theUnited States, as indicated in Table 1. If U.S. work-ers can produce 40 yards of cloth in an hour, theaverage cost of producing a yard of cloth is $0.50($20/40 yards ¼ $0.50 per yard); similarly, the aver-age cost of producing a bottle of wine in the UnitedStates is $0.50. Because Ricardian theory assumesthat markets are perfectly competitive, in the long term a product’s price equals its average cost of production. The prices of cloth and wine producedin the United States are shown in the table.

Suppose now that the wage rate is £5 per hourin the United Kingdom. Thus, the average cost(price) of producing a yard of cloth in the UnitedKingdom is £0.50 (£5/10 yards ¼ £0.50 per yard),and the average cost (price) of producing a bottleof wine is £0.25. These prices are also shown inTable EF 2.1.

Is cloth less expensive in the United States orthe United Kingdom? In which nation is wine lessexpensive? When U.S. prices are expressed in dol-

lars and UK prices are expressed in pounds, wecannot answer this question. We must thereforeexpress all prices in terms of one currency —say,the U.S. dollar. To do this, we must know the prevailing exchange rate at which the pound and thedollar trade for each other.

Suppose the dollar/pound exchange rate is$1.60 ¼ £1. In Table EF 2.1, we see that the UKhourly wage rate (£5) is equivalent to $8 at thisexchange rate (£5 $1.60 ¼ $8). The average dol-lar cost of producing a yard of cloth in the UnitedKingdom is $0.80 ($8/10 yards ¼ $0.80 per yard),and the average dollar cost of producing a bottleof wine is $0.40 ($8/20 bottles ¼ $0.40 per bottle).Compared to the costs of producing these productsin the United States, we see that the United King-dom has lower costs in wine production but highercosts in cloth production. The United Kingdomthus has a comparative advantage in wine.

TABLE EF 2.1

RICARDO’S COMPARATIVE-ADVANTAGE PRINCIPLE EXPRESSED IN MONEY PRICES

CLOTH (YARDS) WINE (BOTTLES)

Nation Labor Input Hourly Wage Rate Quantity Price Quantity Price

United States 1 hour $20 40 $0.50 40 $0.50

United Kingdom 1 hour £5 10 £0.50 20 £0.25

United Kingdom* 1 hour $8 10 $0.80 20 $0.40

*Dollar prices of cloth and wine, when the prevailing exchange rate is $1.60 ¼ £1. This exchange rate was chosen for this example because at other

exchange rates it would not be possible to have balanced trade and balance in the foreign-exchange market.

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N o d i s t r i b u t i o n a l l o w e d w i t h o u t e x p r e s s a u t h o r i z a t i o n .

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We conclude that even though the UnitedKingdom is not as efficient as the United Statesin the production of wine (or cloth), its lower wagerate in terms of dollars more than compensates foritsinefficiency. At this wage rate, the UK average cost

in dollars of producing wine is less than the U.S.average cost. With perfectly competitive markets,the UK selling price is lower than the U.S. selling price, and the United Kingdom exports wine to theUnited States.

2-2 Foundations of Modern Trade Theory: Comparative Advantage

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Exploring Further 2.2

Indifference Curves and Trade

In this section, we introduce indifference curves toshow the role of each country ’s tastes and prefer-ences in determining the autarky points and how gains from trade are distributed.

The role of tastes and preferences can be illus-trated graphically by a consumer’s indifferencecurve. An indifference curve depicts the variouscombinations of two commodities that are equally preferred in the eyes of the consumer; that is, yieldthe same level of satisfaction (utility). The term

indifference curve stems from the idea that theconsumer is indifferent about the many possiblecommodity combinations that provide identicalamounts of satisfaction.

Figure EF 2.1 illustrates a consumer’s indiffer-ence map, which consists of a set of indifferencecurves. Referring to indifference curve I , a con-sumer is just as happy consuming, say, six bushelsof wheat and one auto at point A as consuming three bushels of wheat and two autos at point B.All combination points along an indifference curveare equally desirable because they yield the samelevel of satisfaction. Besides this fundamental char-

acteristic, indifference curves have several otherfeatures:

• Indifference curves pass through every point inthe figure;

• Indifference curves slope downward to theright;

• Indifference curves are bowed in (convex) tothe diagram’s origin;

• Indifference curves never intersect each other;• Indifference curves lying farther from the ori-

gin (higher curves) represent greater levels of satisfaction.

Having developed an indifference curve for

one individual, can we assume that the preferencesof all consumers in the entire nation could beadded up and summarized by a community indif-ference curve? Strictly speaking, the answer is no,

because it is impossible to make interpersonal com-parisons of satisfaction. For example, person A may prefer a lot of coffee and little sugar, but person Bprefers the opposite. The dissimilar nature of indi- viduals’ indifference curves results in their being noncomparable. Despite these theoretical pro-blems, a community indifference curve can beused as a pedagogical device that depicts the roleof consumer preferences in international trade.

Using indifference curves, let us now develop a

trade example to restate the basis-for-trade and thegains-from-trade issues. Figure EF 2.2 depicts thetrading position of the United States. The UnitedStates in the absence of trade will maximize

FIGURE EF 2.1

A CONSUMER’S INDIFFERENCE MAP

543210

6

5

4

3

2

1

W h e

a t

A

B

C

D E

l

Autos

II

III

An indifference map is a graph that illustrates an entire

set of indifference curves. Each higher indifference

curve represents a greater level of satisfaction for the

consumer. A community indifference curve denotes

various combinations of two goods that yield equalamounts of satisfaction to the nation as a whole.

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satisfaction if it can reach the highest attainableindifference curve, given the production constraintof its production possibilities schedule. This willoccur when the U.S. production possibilities sched-ule is just tangent to indifference curve I , at point A. At this point, the U.S. relative price ratio isdenoted by line t U.S., which equals the absolute

slope of the production possibilities curve at thatpoint.Suppose that the United States has a compara-

tive advantage vis-à-vis Canada in the productionof autos. The United States will find it advantageous

to specialize in auto production until the two coun-tries’ relative prices of autos equalize. Supposethis occurs at production point B, where the U.S.price rises to Canada’s price, depicted by line tt .Also suppose that tt becomes the internationalterms-of-trade line. Starting at production point B,the United States will export autos and import

wheat, trading along line tt . The immediate problemthe United States faces is to determine the level of trade that will maximize its satisfaction.

Suppose that the United States exchanges 6autos for 50 bushels of wheat at terms of trade tt .

FIGURE EF 2.2

INDIFFERENCE CURVES AND TRADE

E

C

A

D

B

II

I

United States

tt

t U.S.

24

Autos

1814920

240

290

323

365

423

W h e a t

A nation benefits from international trade if it can achieve a higher level of satisfaction (indifference curve) than it can

attain in the absence of trade. Maximum gains from trade occur at the point where the international terms-of-trade line

is tangent to a community indifference curve.


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This exchange would shift the United States fromproduction point B to post-trade consumptionpoint D. But the United States would be no betteroff with trade than it was in the absence of trade.This is because in both cases the consumptionpoints are located along indifference curve I .Trade volume of 6 autos and 50 bushels of wheatthus represents the minimum acceptable volume of trade for the United States. Any smaller volumewould force the United States to locate on a lowerindifference curve.

Suppose instead that the United States trades22 autos for 183 bushels of wheat. The United

States would move from production point B topost-trade consumption point E . With trade, theUnited States would again locate on indifferencecurve I , resulting in no gains from trade. From theU.S. viewpoint, trade volume of 22 autos and 183

bushels of wheat therefore represents the maxi-mum acceptable volume of trade. Any greater vol-ume would find the United States moving to alower indifference curve.

Trading along terms-of-trade line tt , theUnited States can achieve maximum satisfaction if it exports 15 autos and imports 125 bushels of wheat. The U.S. post-trade consumption locationwould be at point C along indifference curve II ,the highest attainable level of satisfaction. Compar-ing point A and point C reveals that with tradethe United States consumes more wheat, but fewerautos, than it does in the absence of trade. Yet point

C is clearly a preferable consumption location. Thisis because under indifference-curve analysis, thegains from trade are measured in terms of totalsatisfaction rather than in terms of the number of goods consumed.

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2.3 Exploring Further

Offer Curves and the Equilibrium Terms of Trade

John Stuart Mill’s theory of reciprocal demandconsidered the significance of demand’s influenceon the terms of trade. But his theory was somewhat vague and generalized. It was Alfred Marshall whoformally demonstrated the usefulness of offercurves as a graphic method of illustrating how theinteraction of supply and demand determines theequilibrium terms of trade.1

Nature of an Offer CurveAn offer curve depicts the various amounts of two products that a country wishes to trade, givendifferent price ratios. For each price ratio, the offercurve shows how much of one product a country is willing to trade for certain amounts of another

product. Therefore, an offer curve can be thoughtof as both a supply curve and a demand curve.An offer curve is a supply curve in the sense thatit shows the amounts of an export product thatwill be offered for sale at various terms of trade.Reflecting domestic supply factors, such as technol-ogy and resource endowments, an offer curve showsthat more of an export product will be suppliedon the market as its relative price increases. This isespecially plausible if it assumes that the country

produces under increasing cost conditions.In Figure EF 2.3, as the U.S. terms of trade

improve (the terms-of-trade line rotates upward),the United States finds that a given amount of its autos trades for larger quantities of the importgood, wheat. This results in the United States being

1 Marshall, Alfred, The Pure Theory of Foreign Trade, London: London School of Economics and Political Science, 1930.

FIGURE EF 2.3

OFFER CURVE: DEMAND AND SUPPLY INTERPRETATIONS

W 2

W 1

W 0 A

B

C

A1 A0 A2

tt 2

tt 1

tt 0

O

W h e a t ( U . S .

I m p o r t )

Autos (U.S. Export)

U.S.

tt 0 tt 1 tt 2

B9

A9

C9W 2

W 1

W 0

A1 A0 A2

O

W h e a t ( C a n a d a E x p o r t )

Autos (Canada Import)

Canada


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willing to offer more autos for sale. Similarly,improving terms of trade for Canada results in itbeing willing to offer additional amounts of itsexport product (wheat) for sale.

As a demand curve, an offer curve shows thequantities of imports that will be demandedat various terms of trade. Reflecting domesticdemand conditions, the offer curve shows thatmore of the import product will be demanded asits relative price falls. In Figure EF 2.3 [1], we seethat as the terms of trade improve for the UnitedStates, the relative price of its import good falls;that is, it requires fewer auto exports for the

United States to purchase a given quantity of Canadian wheat. The United States thus movesupward along its offer curve, demanding largeramounts of wheat. The reverse holds equally truefor Canada.

Offer Curve Construction

The shape and location of a country ’s offer curveare based on its supply and demand conditions,which are reflected in its production possibilitiescurve and community indifference curve. Thesetools can be used to build an offer curve.

Referring to Figure EF 2.4, suppose that its

upper part represents U.S. production possibilitiesunder increasing cost conditions. Assume that inthe absence of trade the United States achievesthe equilibrium point of production and consump-tion at point R, at which community indifferencecurve I is tangent to the production possibility curve. At this point, the U.S. price ratio is indicatedby t U.S.. With international trade, suppose theUnited States finds the international price ratio tobe given by line tt S. United States production thusmoves to point S, where community indifferencecurve II is tangent to tt S. By exchanging AP S autosfor AS wheat, the United States can attain a post-trade equilibrium at point S. Should the interna-tional price ratio be at tt T, the United States couldproduce at point T , exchanging BP T autos for BT wheat.

To build the U.S. offer curve, first redraw theprice ratios (from the figure’s upper part) in thelower part of the figure as positively sloped lines.At international terms of trade tt S, the United Statescan offer OA (equal to AP S) autos in exchange forOC (equal to AS) wheat. This exchange resultsin point S, one point along the U.S. offer curve. Inlike manner, other points along the offer curve canbe established. The main point to be emphasizedin this example is that the construction of an offercurve reflects both the supply and demand condi-tions of a country.

The Equilibrium Terms of TradeOffer curve analysis is intended to determine therelative prices at which trade actually takes place—that is, the equilibrium terms of trade. By bringing together the supply characteristics embodied ina country ’s production possibilities curve and thedemand preferences depicted in a community indif-ference curve, offer curve analysis exhibits the con-dition of a market equilibrium.

If the existing terms of trade are to be the equi-librium terms of trade, the amount of a productthat a country wants to export must match theamount demanded as imports by another country.

In Figure EF 2.5, point E represents the marketequilibrium of the United States and Canada. Atterms of trade tt 0, the quantity of autos the UnitedStates is willing to export (OA0) equals the quantity of autos demanded by Canada (OA0). In like man-ner, Canada’s wheat exports (OW 0) just match U.S.wheat imports (OW 0). However, what if marketequilibrium does not exist? Are there forces thatwill restore market balance?

Figure EF 2.5 also illustrates a case of marketdisequilibrium. At the terms of trade tt 1, the numberof autos that the United States is willing to supply (OA1) is less than the number of autos demandedby Canada (OA2). A shortage of autos thus exists.At terms of trade tt 1, the amount of wheat thatCanada is willing to supply (OW 2) exceeds theamount demanded by the United States (OW 1).

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FIGURE EF 2.4

CONSTRUCTING AN OFFER CURVE

W h e a t ( U . S .

I m p o r t )

Autos (U.S. Export)

U.S. ProductionFrontier

tt S

PS

PT

t U.S.

tt T

A

B

R

S

T

O

I

II

III

W h e a t ( U . S .

I m p o r t )

U.S.

Autos (U.S. Export)

tt S

tt T

t U.S.

D

C

O A B

T

S


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Therefore, there is a surplus of wheat. The relativeprice of autos will rise and wheat’s relative pricewill fall until all surpluses and shortages are elimi-nated. At equilibrium point E , the supply matchesthe demand for both products. Conversely, ashortage of wheat and a surplus of autos resultsin the relative price of wheat rising and the relativeprice of autos falling until market equilibrium isrestored at point E .

Shifting Offer Curves: Changes in the

Equilibrium Terms of TradeBecause an offer curve is derived from a country ’sproduction possibilities curve and community

indifference curve, changes in the supply anddemand conditions underlying these schedulesinduce a shift in the offer curve’s location. Thisshift in location results in a change in the equilib-rium terms of trade and the volume of trade. Let usconsider two possibilities.

Referring to Figure EF 2.6, suppose the UnitedStates and Canada are initially in equilibrium atpoint E , trading at terms of trade tt 0. Holding con-stant the Canadian supply of resources and tech-nology, suppose that Canada’s demand shifts away from autos, its import good, toward wheat, itsexport good. Because Canada now desires autosless intensely, it is willing to trade less wheat thanbefore for a given number of autos. Canada’s offer

FIGURE EF 2.5

OFFER CURVES AND EQUILIBRIUM TERMS OF TRADE

W 2

tt 0

tt 1

SE

R

W 0

W 1

A1 A0 A2

O

W h e a t ( C a n a d a ’ s E x p o r t )

Autos (U.S. Export)

Canada

U.S.

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curve thus shifts from Canada0 to Canada1. At theinitial terms of trade, tt 0, the market now is indisequilibrium: There exists an excess demand forwheat and an excess supply of autos. The relativeprice of wheat rises until market equilibrium isrestored at point G. Both countries now trade atterms of trade tt 1. This trading situation affectsCanada’s welfare in two ways. The reduction inthe volume of trade reduces its welfare, but theimproving terms of trade increases its welfare.The actual effect that these opposing forces haveon Canada’s welfare depends on their relative

strength. It is left to the reader to verify that if Canada’s demand shifts away from wheat toautos, its terms of trade will worsen and its volumeof trade will increase.

Referring to Figure EF 2.7, again assume thatthe United States and Canada are initially in equi-librium at point E , trading at terms of trade tt 0.Holding constant U.S. demand for wheat andautos, suppose that technological advances resultin the United States becoming more productive inmanufacturing autos, its exportable good. This pro-ductivity causes a rightward shift in the U.S. offer

FIGURE EF 2.6

CHANGES IN THE TERMS OF TRADE: INCREASED DEMAND FOR EXPORT GOOD

tt 0

tt 1

W 2

W 1

W 0

U.S.0

Canada0

Canada1

A1 A0 A2

O

W h e a t ( C a n a d a ’ s

E x p o r t )

Autos (U.S. Export)

F

E

G


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curve, from U.S.0 to U.S.1. At point F on the initial

terms-of-trade line tt 0, the United States is now will-ing to sell a larger number of autos than Canada iswilling to purchase. Market equilibrium is restored

at point G, when the fall in the relative price of autos

is sufficient to clear the market of the surplus of autos. Therefore, the terms of trade worsen for theUnited States although its volume of trade increases.

FIGURE EF 2.7

CHANGES IN THE TERMS OF TRADE: INCREASED SUPPLY OF EXPORT PRODUCT

tt 0

tt 1

U.S.0 U.S.1

Canada0W 0

W 1

W 2

A1 A2 A0

O

W h e a t ( C

a n a d a ’ s E x p o r t )

Autos (U.S. Export)

E G

F

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