In Canada, one unit of wheat is equal to two units of candy; therefore, Canada would like to get one unit of wheat by
exporting anything less than two units of candy. Canada’s goal is to get a better deal internationally than its domestic
rate for wheat and candy. The Canadians can make two units of candy for each one unit of wheat. This ratio has already
told us that Canada should specialize in candy; however, at what exchange rate will Canada benefit the most for wheat?
The terms of trade will fall between:
U.S. = 1 unit of wheat = 1 unit of candy
Canada = 1 unit of wheat = 2 units of candyCanada prefers the terms of exchange to fall closer to its ratios, and the United States prefers the terms of exchange
to fall closer to its ratios. The goal for the Canadians is to get as much wheat for their candy because that’s what the
Canadians specialize in. The goal for Americans is to get as much candy for their wheat because that’s what the United
States specializes in.
In actuality, the exchange ratio depends on the international forces of supply and demand. If the world supply for wheat
is high, then the United States will have to give a little on its price for wheat when trading to Canada. Similarly, if the
world supply for candy is high, the Canadians will lose price leverage on their candy and will have to give a little when
trading with the United States. This does not mean each country cannot benefit from trade—it just means that according
to the international forces of supply and demand, one country may have to benefit a little less than the other. Both coun-
tries still benefit from trade.
For the sake of our example, let’s try to find some middle ground for the terms of trade between the United States and
Canada. Assume that the exchange rate for candy and wheat is one unit of wheat for one and one-half units of candy.
Figure 12-2 illustrates the gains both countries have as a result of trade.
Figure 12-2By examining the graphs, we can see that the production possibilities for each country have increased due to trade.
Both parties have benefited as a result of trade. Canada has more wheat for its candy, and the United States has more
candy for its wheat.
For the AP exam, you will be expected to discover the absolute and comparative advantage for the entities involved.
You will then be expected to construct production possibilities graphs that illustrate gains from trade for each country.
Candy UnitsUnited StatesWheat Units201053040500 5 10 20 30Candy UnitsCanadaWheat Units2010530400 5 10 20 30de
rarTftesAitiebilssiPoion
ctdu
ro
PdeTrautthoWiies
ilitsib
os
Pion
ctduPro rade
TromtFefi
en
BdeTra
uttho
isWltiie
ibiossnPctoi
duProdeTrater
Afies
ilitsib
osnPctioduProdeTraom
FrinsGaInternational Economics