In a two by two model of international trade, it is assumed that

Analyze the question: The "two by two model" of international trade means two countries and two goods. The question asks what this model assumes about gains from trade and the terms of trade.

Concept: The theory of comparative advantage (Ricardo) says each country specialises in the good where its opportunity cost is lower, then trades. The terms of trade is the rate at which one good exchanges for the other, i.e. the ratio of export prices to import prices.

• Trade is only beneficial if the terms of trade lie between the two countries' domestic opportunity cost ratios.
• Within that range, the terms of trade decide how the gains are shared. The closer the terms of trade are to a country's own domestic cost ratio, the smaller its share. The closer to the partner's ratio, the larger its share.

Worked example:

• Country X: 1 cloth = 2 wheat (domestic cost)
• Country Y: 1 cloth = 4 wheat (domestic cost)
• X exports cloth and Y exports wheat. Any terms of trade between 2 and 4 wheat per cloth benefit both.
• At 3 wheat per cloth, X gets 1 extra wheat per cloth and Y saves 1 wheat per cloth.
• At 2.5 wheat per cloth, X gains little and Y gains a lot.

So both countries gain at the same time, and the size of each country's gain depends on the terms of trade.

Checking the options:

• A: wrong. The terms of trade do matter for how the gains are distributed.
• B: correct. Both gain, and the volume of gains depends on the terms of trade.
• C: wrong. Countries can gain from trade.
• D: wrong. It contradicts the point that the gains depend on the terms of trade.

Exam tip: In comparative advantage questions, remember "both gain, and the terms of trade decide who gets more." If an option says the terms of trade are irrelevant to the gains, it is almost always wrong.