Part III: Microeconomics
Figure 12-1The United States can operate efficiently on its production possibilities curve by trading off one unit of wheat for one
unit of candy or one unit of candy for one unit of wheat. The domestic exchange ratio in the United States is 1 for 1. In
Canada, 20 units of candy must be given up to get 10 units of wheat. This means that the ratio or opportunity cost of
candy and wheat is two units of candy for one unit of wheat.
Canada and the United States will have to choose a level of output that is beneficial to both countries. Each country selects
an output that provides the greatest utility for the country’s economy. Let’s assume that points X and Y in the figures are
the best production possibilities for both countries. This assumption simply means that each country’s most desirable out-
put of candy and wheat is located at X and Y. The domestic equilibrium is located at X and Y for each country.
The idea of comparative advantage states that total output will be greatest for the countries if each specializes in the
good for which it has the lowest opportunity cost. In our example, we can see that the United States has the lower op-
portunity cost if it specializes in wheat (U.S.: one unit of wheat for one unit of candy; Canada: two units of candy for
one unit of wheat). It would not be in Canada’s best interest to specialize in wheat because it would be giving up two
units of candy for one unit of wheat, when the United States could be used as a trading partner. The whole idea here is
to let a country produce a good that is in demand for you because they have an easier time producing it. Why would
Canada employ valuable resources to produce a good that could be attained more easily with a trading partner?
Canada has the lower opportunity cost when it comes to producing candy because they are giving up only half a unit
of wheat when producing one unit of candy. The United States has to give up one unit of wheat for one unit of candy,
which makes the United States’ opportunity cost higher than Canada’s.
In our analysis, we have discovered that the United States should specialize in wheat and Canada should specialize in
candy. If the United States specializes in wheat, then it will be able to make 30 units of wheat at capacity and 0 units
of candy. If Canada specializes in candy, then it will be able to make 20 units of candy and 0 units of wheat. People in
both countries are still going to want wheat (in Canada) and candy (in the United States), so what should the countries
do? Trade!
Trading Terms
The United States and Canada must come to an agreement with the terms of trade. They already know that they need
each other’s good. What they need to determine is what will it take to get the goods for trade. In the United States, the
domestic opportunity cost is one unit of candy for one unit of wheat. For the United States to benefit from trade, it must
obtain more than one unit of candy for each unit of wheat exported or it will not benefit from exporting wheat in exchange
for candy. The whole point here is for the United States to get a better deal internationally than it does domestically for its
products.
Candy United StatesWheat20X
10125300 5 10 18 2 0 3 0Candy CanadaWheat20Y105
4300 5 8203010