BEC - Terms of Trade Lesson

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Terms of Trade Lesson

Specialization and Trade Video

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Establishing Mutually Advantageous Terms of Trade

Once comparative advantage has been determined, each country should specialize in the good for which they have the advantage. The result would be greater production.   However, the countries would then need to trade because they desire both goods, not just the good they individually produced. The result would be better allocation of the goods/services. In order for trade to occur, the terms of trade established must be mutually advantageous. Mutually advantageous terms of trade exist when the trade ratio is set somewhere between the two opportunity costs for a good for each nation.  

Exchange Rates Video

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Additional Comments on International Trade

Because countries use various currencies that have different values, international trade requires the conversion of currencies in the foreign exchange market. When currencies are traded, the basic laws of supply and demand dictate the rate at which one currency is traded for another. It is important to note that the value of a currency is relative to another currency. For example, if the U.S. dollar appreciates (strengthens) in value, it is relative to another currency, such as the Mexican peso. By appreciating, the U.S. dollar now commands a greater number of pesos to be traded in return for one dollar. Of course, if the U.S. dollar depreciates (weakens) relative to the Mexican peso, it commands a smaller number of pesos to be traded for one dollar. When the U.S. dollar appreciates relative to the Mexican peso, it can be said that the peso has depreciated in value. When the U.S. dollar depreciates relative to the Mexican peso, it is true that the peso has appreciated in value. They are flipped sides of the same coin.  

Imports, Exports and Exchange Rates Video

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Remember, in general economists believe that trade is good for two main reasons: greater production and better allocation. As a result, economists will often be in favor of policies that promote free trade. However, there are some opponents of free trade. Opponents of free trade, or Protectionists, are in favor of limiting trade through the use of tariffs, quotas, and embargoes. The arguments for and against free trade are summarized in the diagram below.

For Free Trade vs. Against Free Trade

For Free Trade • Greater Production: Specialization between countries allows each country to produce what it is best at; leads to greater variety and greater total production of goods • Better Allocation: Trade allows goods/services/resources to move to areas where they are most desired; allows countries to consume beyond their PPCs • Leads to competition and innovation which benefit consumers • General increase in national income for parties involved in trade Against Free Trade • Lesser developed countries are taken advantage of by wealthier nations (politically, economically) • Results in greater economic interdependence between nations • Results in job losses at home • Lack of quality control on imports could result in harmful products • Developing industries in a nation are not protected from competition from cheaper imported goods • Can result in trade deficits

Why do Countries Restrict Trade Video

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