Figure 32-7 An Improvement in the Terms of Trade
32-7 , indicates that only a small amount of cloth must be given up to get
more wheat; thus cloth is relatively costly and wheat is relatively cheap.
In contrast, a flatter production possibilities boundary indicates that a
larger amount of cloth must be given up to get more wheat; thus cloth is
relatively cheap and wheat is relatively expensive.
Changes in the terms of trade lead to changes in a country’s
consumption possibilities. The purple line shows the hypothetical
production possibilities boundary for Canada. With international trade at
relative prices Canada specializes in the production of wheat,
producing at point S, but is able to consume at a point like A. It pays for
its imports of cloth with its exports of wheat.
If the price of wheat rises relative to the price of cloth, production remains
at S but the line shows Canada’s new consumption possibilities.
Consumption can now take place at a point like B where consumption of
both wheat and cloth has increased. The increase in the terms of trade
makes Canada better off because of the increase in consumption
possibilities.
T 0 ,T 1