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IAI Actuarial Core Principles · Business Economics · Importance of international trade

Two countries specialise according to comparative advantage and trade at terms of trade lying strictly between their domestic opportunity cost ratios. Which statement about the outcome is correct?

Both countries can consume beyond their own pre-trade production possibility frontiers. With terms of trade between the two opportunity costs, each obtains the imported good more cheaply than it could produce it. Gains do not require an absolute advantage, and neither country need lose.

  1. AOnly the country with an absolute advantage in both goods gains
  2. BBoth countries can consume beyond their pre-trade production possibility frontiersCorrect
  3. CTotal world output of every good must rise by the same proportion
  4. DGains arise only if the terms of trade equal one country's opportunity cost
  5. The country with lower productivity loses because its workers earn less

Explanation

When terms of trade lie strictly between the two opportunity cost ratios, each country obtains a good more cheaply than at home, so both can consume outside their own frontiers. If terms equal one country's opportunity cost, that country gains nothing, so option 3 is false. Absolute advantage is not required for gains.

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