Key Diagrams - Gains from Trade using a PPF Diagram

In this video we walk through an example of using a PPF diagram to show the potential gains from specialisation and trade between two countries.

You can use a PPF diagram to show the potential gains from specialisation and trade based on the law of comparative advantage.

Key to this diagram is to make a clear difference in the relative opportunity cost for two countries engaged in trade.

In the diagram we will walk through,Brazil has the absolute advantage – it can produce more of both wine and steel – but Mexico has a comparative advantage in wine production.

If both countries specialise according to comparative advantage and then trade at a mutually beneficial terms of trade (which in this case is 2 units of steel for 3 units of wine), then both nations can increase consumption of both products.

In this sense, their consumption possibility frontier with trade lies outside their domestic production possibility frontier. A great example to use of the potential economic welfare gains from trade.

Important when using this analysis diagram to state the assumptions underlying the theory:

1.Constant returns

2.Factor mobility between industries

3.Very low trade frictions to allow trade to take place

4.Absence of externalities

You can also use standard supply and demand curve analysis diagrams to show some of the welfare effects of trade and also how it impacts onconsumer and producer surplus.