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A-Level Economics · Comparative advantage and the gains from trade diagram question

What determines where the terms-of-trade line can lie?

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The diagram

The answer

Trade only happens if the rate of exchange lies BETWEEN the two countries' opportunity-cost ratios. Between the two opportunity-cost ratios. Outside that range one side would rather make the good itself, so no trade happens — money is just the means of exchange. Each country compares the world rate with its own opportunity cost. If the rate at which the goods exchange sits between the two countries' ratios, both do better than producing for themselves — and even on unfavourable terms, anywhere along that line beats being stuck on your own frontier. Push the rate outside the range and one side simply walks away.

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This is one of 6 questions on the comparative advantage and the gains from trade diagram — every corner lettered, every wrong answer diagnosed.

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