If, through international trade, Canada has access to different relative
prices, Canada will be led to specialize in the production of one good or
the other. In Figure 32-7 , we show a case in which the world relative
price of cloth is lower than the relative price Canada would have if it did
not trade. (This lower world relative price of cloth reflects the fact that
other countries can produce cloth more cheaply than Canada.) Faced with
a lower relative price of cloth, Canada ends up specializing in the
production of the relatively high-priced product (wheat), and importing
the relatively low-priced product (cloth). This point of specialization is
point S in Figure 32-7.
The upper two green lines in the figure show alternative values of the
world relative prices—that is, alternative values for Canada’s terms of
trade. A rise in the terms of trade indicates a fall in the relative price of
cloth (or a rise in the relative price of wheat). This increase in the terms of
trade is shown as an upward rotation of the green line from to
reduction in the terms of trade is shown as a downward rotation in the
green line, from to
It should be clear from Figure 32-7 why changes in the terms of trade
are important. Suppose the international relative prices are initially given
by Canada specializes in the production of wheat (point S) but
consumes at some point like A, where it finances its imports of cloth with
exports of wheat. Now suppose there is a shift in world demand toward
wheat and away from cloth, and this leads to an increase in the relative
price of wheat. The terms of trade increase to and, with unchanged
T 0 T 1.T 1 T 0.T 0.T 1