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ModULE 1.3
Mutually Beneficial Terms of Trade

The terms of trade indicate the rate at which one good can be exchanged for another. The terms of trade indicate the
In our story, Alexis and Jacob traded 10 coconuts for 10 fish, so each coconut traded rate at which one good can be
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for 1 fish. Why not some other terms of trade, such as ⁄4 fish per coconut? Indeed, exchanged for another.
there are many terms of trade that would make both Alexis and Jacob better off than if
they didn’t trade. There are also terms that Alexis or Jacob would certainly reject. For
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example, Alexis would not trade 2 fish per coconut, because she only gives up ⁄3 fish
per coconut without trade.
To find the range of mutually beneficial terms of trade for a coconut, look at each
person’s opportunity cost of producing a coconut. Any price per coconut between the oppor-
tunity cost of the coconut producer and the opportunity cost of the coconut buyer will make both sides
better off than in the absence of trade. We know that Jacob will produce coconuts because he
has a comparative advantage in gathering coconuts. Jacob’s opportunity cost is ⁄2 fish
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per coconut. Alexis, the buyer of coconuts, has an opportunity cost of ⁄3 fish per coco-
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nut. So any terms of trade between ⁄2 fish per coconut and ⁄3 fish per coconut would
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benefit both Alexis and Jacob.
To understand why, consider the opportunity costs summarized in Table 1.3-1
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When Jacob doesn’t trade with Alexis, Jacob can gain ⁄2 fish by giving up a coconut,
because his opportunity cost of each coconut is ⁄2 fish. Jacob will clearly reject any
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deal with Alexis that provides him with less than ⁄2 fish per coconut — he’s better off
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not trading at all and getting ⁄2 fish per coconut. But Jacob benefits from trade if he
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receives more than ⁄2 fish per coconut. So the terms of 1 fish per coconut, as in our
story, are acceptable to Jacob.
It also makes sense from Alexis’s perspective. When Alexis doesn’t trade with Jacob, AP ECoN TIP
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Alexis gives up ⁄3 fish to get a coconut — her opportunity cost of a coconut is ⁄3 fish.
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Alexis will reject any deal that requires her to pay more than ⁄3 fish per coconut. But The mutually beneficial
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Alexis benefits from trade if she pays less than ⁄3 fish per coconut. The terms of 1 fish terms of trade for a good
per coconut are thus acceptable to Alexis as well. Both islanders would also be made fall between the producer’s
better off by terms of ⁄4 fish per coconut or ⁄4 fish per coconut or any other price opportunity cost for the good
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between ⁄2 fish and ⁄3 fish per coconut. Their negotiation skills determine where the and the buyer’s opportunity
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terms of trade fall within that range. cost for the good.
So remember, Alexis and Jacob will engage in trade only if the “price” of the good
each person obtains from trade is less than their own opportunity cost of producing
the good. The same is true for international trade. Whenever two parties trade volun-
tarily, the terms of trade for each good are found between the opportunity cost of the
producer and the opportunity cost of the buyer.
The story of Alexis and Jacob clearly simplifies reality. Yet it teaches us some very
important lessons that also apply to the real economy. First, the story illustrates the
gains from trade. By agreeing to specialize and trade, Alexis and Jacob can each consume
more of both goods than if each tried to be self-sufficient. Second, the story demon-
strates a key point that is often overlooked in real-world arguments: as long as potential AP ECoN TIP
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trading partners have different opportunity costs, each has a comparative advantage in some-
thing and each has a comparative disadvantage in something else, so each can benefit from trade. The producer with the
The idea of comparative advantage applies to many activities in the economy. Per- absolute advantage can
haps its most important application is in trade — not between individuals, but between produce the largest quantity
countries. So let’s look briefly at how the model of comparative advantage helps us of the good. However, it
understand both the causes and the effects of international trade. is the producer with the
comparative advantage, and
Comparative Advantage and International Trade not necessarily the one with
the absolute advantage,
International trade provides much of what we buy. Look at the label on most manu- who should specialize in the
factured goods sold in the United States, and you will probably find it was produced in production of that good to
some other country — in China, Japan, or even Canada. On the other hand, many U.S. achieve mutual gains from
industries sell a large portion of their output overseas. This is particularly true for the trade.
agriculture, high technology, and entertainment industries.

Module 1.3 Comparative Advantage and Gains from Trade 23
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