Two countries, New Zealand and Australia, can each make dairy and electronics. Each has a straight-line production possibility curve (PPC): it can make up to so much dairy, or so much electronics, or any mix on the line between. Both countries are taken to have the same quantity of resources. The figures are made up, to show the idea.
Use it to explain why countries specialise and trade, and when both of them gain.
Reading the diagrams
- Each country has its own diagram: dairy along the bottom, electronics up the side. The solid line is its PPC. If you change a country's sliders, the dashed line shows where its PPC started.
- C1 is what the country makes and consumes before trade: with no trade, it can only consume what it produces, so C1 is on its PPC. The Resources on dairy slider moves it along the PPC.
- Choose Specialise and trade in the title bar. P is what each country now produces, and the coloured line through P is its trading possibility curve (TPC): every combination it can consume by trading from P at the terms of trade. C2 is what it consumes after trade. Green shading between the TPC and the PPC is consumption that trade makes possible; red shading means the TPC lies inside the PPC, so the country would be better off not trading.
The key formulae
- Opportunity cost of 1 dairy = most electronics ÷ most dairy. Opportunity cost of 1 electronics = most dairy ÷ most electronics. The two are always reciprocals: if 1 dairy costs 0.5 electronics, 1 electronics costs 2 dairy.
- Absolute advantage: the country that can make more of the good with the same resources (the bigger intercept on that good's axis).
- Comparative advantage: the country with the lower opportunity cost of the good. If one country has the comparative advantage in dairy, the other must have it in electronics.
- Terms of trade (here, how many electronics 1 dairy exchanges for): both countries gain only if it is between their two opportunity costs of dairy. The dairy exporter must get more electronics than it gives up to make a dairy unit; the importer must pay fewer than it would give up to make one itself. The shaded part of the bar is that range.
- Gain from specialisation = world output after − world output before, for each good.
Specialising
- Each country moves its resources towards its comparative advantage good. Where full specialisation (each making only its own good) gives the world more of both goods, both specialise fully.
- If full specialisation would leave the world with less of one good than before trade, which can happen when one country has an absolute advantage in both, one country specialises partly: it keeps making a little of the other good, so the world ends up with more of both.
- The amount traded is chosen in the middle of the range where neither country consumes less of either good than before, when the terms of trade allow one.
- If the opportunity costs are equal, neither country has a comparative advantage: specialising can't raise world output, and there are no gains from trade.
The sliders
- Most dairy / most electronics: where each country's PPC meets the axes. These set the opportunity costs and the advantages.
- Resources on dairy: the share of the country's resources making dairy before trade, which places C1.
- Terms of trade: the price of dairy in electronics. Inside the shaded range both countries gain; outside it, one of them loses.
Limitations of the model
- Transport costs are ignored. They narrow the gains, and if they're bigger than the difference in opportunity costs, trade isn't worth it.
- Constant opportunity costs (straight-line PPCs) are assumed. In reality costs usually rise as a country specialises (diminishing returns), so full specialisation is less likely, and economies of scale could make costs fall instead.
- Two goods and two countries only, with resources that move freely and instantly between industries. Real workers and machines are not perfectly mobile, so specialising causes structural unemployment for a while.
- Barriers to trade such as tariffs and quotas (protectionism) are assumed away: the model shows free trade.
- It says nothing about how the gains are shared within each country, and specialising makes a country depend on others and on the world price of its export.
IGCSE view
Choose IGCSE in the title bar to hide the terms of trade and see specialisation simply: when each country concentrates on the good it is relatively best at making, total world output rises. Advantages of specialisation at national level: more output, lower costs and economies of scale, more choice through trade. Disadvantages: dependence on other countries, the risk of a fall in demand for the country's export, and unemployment if its industries decline.
Common exam mistakes
- Thinking a country with an absolute advantage in both goods can't gain from trade. Comparative advantage, not absolute advantage, decides what to specialise in: try the first example.
- Getting the opportunity cost upside down: the cost of 1 dairy is the electronics given up, so divide the electronics by the dairy.
- Saying both countries gain at any terms of trade. They must be between the two opportunity cost ratios.
- Drawing the trading possibility curve through the origin, or from the before-trade point. It starts from the specialised production point, P, with a slope set by the terms of trade.
Objective: explain absolute and comparative advantage, specialisation, the terms of trade and the gains from trade, using production possibility curves and trading possibility curves (Cambridge International AS Level Economics 9708: the reasons for international trade), and the advantages and disadvantages of specialisation at national level (Cambridge IGCSE Economics 0455).
Where this fits
- AP: AP Macroeconomics; AP Microeconomics
- AQA: AQA A Level Economics (7136)
- Cambridge: Cambridge A Level Economics (9708); Cambridge AS Level Economics (9708)
- IB: IB Economics HL
- Pearson Edexcel International: Edexcel International A Level Economics
- USDP: USDP Economics
