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Trade Efficiency Rule

Understanding how focused production can lead to lower prices

What is the Trade Efficiency Rule?

The trade efficiency rule is an economic paradigm where all producers in a global economy specialize in the production of one good. The premise of the rule is that doing so will enable manufacturers to become “experts” at production and thus will be able to produce a given good at a lower cost than a non-specialized producer.

 

Trade Efficiency Rule

 

As a result, the price of the good will decrease since the focus on manufacturing will allow producers to charge less and remain profitable. In an ideal global economy, there would be a production specialist nation for each major good. Thus, goods in the economy would generally be cheaper to produce and more affordable for consumers.

 

How can the Trade Efficiency Rule be measured?

The degree to which a nation observes the trade efficiency rule for one particular good can be measured by taking a look at that its production-possibilities frontier. A nation’s production-possibilities frontier will show us how many units of certain goods it is able to produce given its constraints on available labor and capital. More specifically, the slope of that nation’s production-possibilities frontier will dictate which goods the nation is better at producing than the other.

Consider the following two nations, A and B, which both have the same amount of available labor and capital. For simplicity, we will assume that both nations only produce two goods: apples and oranges. The two nations’ respective production-possibilities frontiers will look like below:

 

Trade Efficiency Rule Charts

 

By looking at Nation A’s production-possibilities frontier, we can see that the country is more adept at producing apples. If Nation A were to devote all of its capital and labor resources to apple production, we could see that it would be able to output 1,000 units of apples. By contrast, looking at Nation B’s production-possibilities frontier, we can see that only 500 units of apples can be produced if all capital and labor resources are devoted to apples.

However, we can see that Nation B is much more adept at producing oranges. If Nation B were to devote all of its capital and labor resources to orange production, we could see that it will be able to output 1,000 units of oranges. By contrast, looking at Nation A’s production-possibilities frontier, we can see that only 500 units of oranges can be produced if all capital and labor resources are devoted to oranges.

In such a scenario, the Trade Efficiency Rule would state that Nation A should produce apples solely, and that Nation B should produce oranges solely. It will maximize the supply of both goods, which will in turn place downward pressure on the prices of the goods. In the long run, both nations will also be able to further tailor their production methods to drive production costs down even further.

 

Competitive Markets

While having a global economy that follows the Trade Efficiency Rule may sound like a great idea to consumers, there are some risks associated with doing so. Namely, one single producer will become so adept at production a particular good that they will eventually be able to exercise monopoly pricing.

As one nation becomes impossible to beat on cost, fewer and fewer nations will choose to compete with that nation at producing a particular good and will turn to producing other goods. Thus, fewer players will exist in the market, which may grant a lot of market power to a single nation.

Nonetheless, the likelihood of such a phenomenon materializing in real life is quite low as modern economies produce a multitude of goods and are able to compete in several industries at the same time.

 

More Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources:

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