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Gains from Trade

  • Gains from trade refer to various benefits which country derived out of international trade.
  • Gains from trade are the net benefits to economic agents for being allowed and increase involuntary trading with each other.
  •  In technical terms, they are the increase of consumer surplus Plus producer surplus from lower tariffs or otherwise liberalizing trade.
  • It also refers to that advantages which different countries participating in international trade enjoy as a result of specialization and division of labor.
  • The Gains from trade are the benefits from trading rather than producing i.e. the benefits that accrue to each country to a transaction over and above the benefits each would have derived from producing the goods or services themselves.

Gains from Trade under Constant Cost

  • Under constant cost conditions, international trade, according to the comparative cost advantage, leads to complete specialization.
  • In other words, each country specializes in the production of the single good in which it has comparative advantage.
  • Combined output of all the goods increases after trade. The gains from international trade are divided among the trading countries according to the international exchange ratio.
Figure 1: Constant Cost

Description

  • In the absence of trade, the United States might choose to produce and consume combination A (90W and 60C) on its production possibility frontier, and the United Kingdom might choose combination A’ (40W and 40C).
  • With trade possible, the United States would specialize in the production of wheat (the commodity of its comparative advantage) and produce at point B (180W and 0C) on its production possibility frontier.
  •  Similarly, the United Kingdom would specialize in the production of cloth and produce at B’ (0W and 120C).
  • If the United States then exchanges 70W for 70C with the United Kingdom, it ends up consuming at point E (110W and 70C), and the United Kingdom ends up consuming at E’ (70W and 50C).
  • Thus, the United States gains 20W and 10C from trade , and the United Kingdom gains 30W and 10C (compare point A’ with point E’ ).
  • The increased consumption of both wheat and cloth in both nations was made possible by the increased output that resulted as each nation specialized in the production of the commodity of its comparative advantage.
  • That is, in the absence of trade, the United States produced 90W and the United Kingdom 40W, for a total of 130W. With specialization in production and trade, 180W are produced (all in the United States).
  • Similarly, in the absence of trade, the United States produced 60C and the United Kingdom 40C, for a total of 100C. With specialization in production and trade, 120C are produced (all in the United Kingdom).
  • It is this increase in output of 50W and 20C resulting from specialization in production that is shared by the United States and the United Kingdom and represents their gains from trade.
  • In the absence of trade, the United States would not specialize in the production of wheat because it also wanted to consume some cloth. Similarly, the United Kingdom would not specialize in the production of cloth in the absence of trade because it also wanted to consume some wheat.

Gains from Trade under Increasing Costs

  • Each nation specializes in producing the commodity of its comparative advantage, it incurs increasing opportunity costs.
  • Specialization will continue until relative commodity prices in the two nations become equal at the level at which trade is in equilibrium.
  • By then trading with each other, both nations end up consuming more than in the absence of trade.
Figure 2: Increasing cost

Description

  • Suppose that trade between the two nations becomes possible (e.g., through the elimination of government obstacles to trade or a drastic reduction in transportation costs). Nation 1 should now specialize in the production and export of commodity X in exchange for commodity Y from Nation 2.
  • Starting from point A (the equilibrium point in isolation), as Nation 1 specializes in the production of X and moves down its production frontier, it incurs increasing opportunity costs in the production of X. This is reflected in the increasing slope of its production frontier.
  • Starting from point A’, as Nation 2 specializes in the production of Y and moves upward along its production frontier, it experiences increasing opportunity costs in the production of Y. This is reflected in the decline in the slope of its production frontier (a reduction in the opportunity cost of X, which means a rise in the opportunity cost of Y).
  • This process of specialization in production continues until relative commodity prices (the slope of the production frontiers) become equal in the two nations. The common relative price (slope) with trade will be somewhere between the pre-trade relative prices of 1/ 4 and 4, at the level at which trade is balanced. In Figure 2, this is PB = PB’ = 1.
  • With trade, Nation 1 moves from point A down to point B in production. By then exchanging 60X for 60Y with Nation 2 (see trade triangle BCE), Nation 1 ends up consuming at point E (70X and 80Y) on its indifference curve III. This is the highest level of satisfaction that Nation 1 can reach with trade at PX /PY = 1.
  • Thus, Nation 1 gains 20X and 20Y from its no-trade equilibrium point. (Compare point E on indifference curve III with point A on indifference curve I.) Line BE is called the trade possibilities line or, simply, trade line because trade takes place along this line.
  •  Similarly, Nation 2 moves from point A up to point B in production, and, by exchanging 60Y for 60X with Nation 1 (see trade triangle B’ C’ E’), it ends up consuming at point E’ (100X and 60Y) on its indifference curve III’.
  • Thus, Nation 2 also gains 20X and 20Y from specialization in production and trade.

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