THE GAINS FROM INTERNATIONAL TRADE

DR. LAXMI NARAYAN YADAVASSISTANT PROFESSOR OF ECONOMICS

GOVT. P.G. COLLEGE MAHENDERGARH

E-mail: laxmi_narayan70@yahoo.com

OUTLINE

Definition

Kind of Gains from Trade

Sources of Gains from Trade

Determinants of Gains from Trade

Measurement of Gains from Trade

Size of the Country and Gains from Trade

DEFINITION

Gains from International trade refers to that advantages which different countries participating in international trade enjoy as a result of specialization and division of labour.

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.

STATIC GAINS: Static gains are the gains from the reallocation of factors of production in sectors where the country has a comparative advantage. Static gains can be reaped immediately in the short-run through more efficient allocation.

DYNAMIC GAINS: Dynamic gains are those gains which accumulates over a period of time. Dynamic gains accrue only over time in less obvious and direct ways.

KINDS OF GAINS FROM TRADE

Maximisation of Production i.e efficiency gains from exploiting comparative advantage

Increase in Welfare

Increase in National Income

Reduced Costs from Economies of Scale

Increased Product Variety

Vent for Surplus

STATIC GAINS FROM TRADE

Efficient Utilisation of Resources

Widening of the Market

Increase in Saving and Investment

Educational Effect (Learning by importing and learning by exporting)

Checking of Monopolies

Increase in Competition

DYANAMIC GAINS FROM TRADE

SOURCES OF GAINS FROM INTERNATIONAL TRADE

Expansion of the Size of the Market

Division of Labour

Gains from Specialisation

Gains from Increased Product Variety

Gains from Increased Competition

Gains from Increased Economies of Scale

Productivity Gains

DETERMINANTS OF GAINS FROM INTERNATIONAL TRADE

TERMS OF TRADE: Terms of trade refers to the rate at which the goods of one country are exchanged for the goods of another country. Country with better term of trade gains more.

RECIPROCAL DEMAND: If the demand of a country for the production of another country is inelastic, terms of trade will be unfavourable.

DIFFERENCE IN COST RATIOS: More the difference in the cost ratios of two countries, more is the gain from international trade.

…..Cont’d

IMPROVEMENT IN PRODUCTIVITY: With improvement in productivity, costs and prices fall in both the countries leading to enlargement of productivity gains.

STAGE OF DEVELOPMENT: An industrialist advanced and capital rich country generally enjoys a larger share of the gain of trade than an economically backward and labour-abundant country.

SIZE OF THE COUNTRY: Inverse relationship between size of the country and gains from trade. A smaller country gains more from specialisation.

…..Cont’d

NATURE OF EXPORT GOODS: A country exporting primary goods have adverse term of trade and gains less from trade whereas a country exporting manufacturing goods gains more from trade.

TRANSPORT COSTS: High transport costs limits the gains from trade. An decrease in transportation costs increases the gains from trade.

COMPETITION AND MONOPOLY: Goods having production in many countries faces more competition and hence the gains from trade will be less to the countries exporting these goods.

MEASUREMENNT OF GAINS FROM INTERNATIONAL TRADE

TRADITIONAL VIEW

Reduction in Production Costs (Ricardo Approach) Terms of Trade (Mills Approach) Increase in Real Income

MODERN VIEW

RICARDO APPROACH FOR MEASUREMENT OF GAINS

• Reduction in the total real costs is the basis of gains.

• A country will export those commodities in which its comparative production costs are less and will import those commodities in which comparative production costs are high.

• The country thus economises in the use of its resources, obtaining for a given amount thereof a larger total income than if it attempted to produce everything at home. The difference between the two is its gain from trade.

OX - Commodity

Y -

Com

mod

ity

A

B

C

.E

.FA`

B`

Before Trade: AB is the PPC curve of the country. Point E indicates equilibrium position before trade.

After Trade: PPC shifts and take the shape of BC. Slope of BC shows international price ratio. Suppose the country is in equilibrium at point F on BC curve, then to produce there it would have to increase its labour such as to shift its PPC to A`B`

The amount of gains from trade will be BB`/OB

OX - Commodity

Y -

Com

mod

ity

A

B

C

.E

.FA`

B`

G

A0

B0

Malthus criticised that Ricardo has greatly over-estimated the gains. He argued that F will not be the equilibrium point. He opined that consumer will prefer a point right of F on A`B`.

CI

Findlay has modified gains from trade by introducing indifference curve CI. If the labour input is increased sufficiently to push PPC to A0B0 instead of A`B`, the point G on CI will give equal satisfaction as in F.

The amount of gains from trade will be BB0/OB

.

J.S. MILL APPROACH

• The Ricardo analysis does not show the exact position of quantum of gains and how they are distributed.

• John Stuart Mill had resolved the problem of how to exactly reach the rate of exchange in international market.

• According to Mills it is the reciprocal demand that actually determines the prevailing terms of trade and the gains obtained by a particular country.

• In his view import, or in other words, demand, must be of much more importance than export in determining the real terms of trade.

• When a country participate trade it firstly takes the status as a demander. Another status of a trader, supplier, is just derived there from.

• It is the relative extensibility of reciprocal demand that actually determines the real terms of trade and consequently the distribution of possible total gains from trade between the two trade partners.

• Suppose India has a comparative advantage in wheat and enormous demand for auto. And U.S.A. has a comparative advantage in auto and enormous demand for wheat.

• The equilibrium terms of trade depend on both Indian demand for auto and wheat as well as U.S.A. demand for these two goods.

• If the Indian demand for auto is stronger, term of trade will be close to Indian price ratio. And if the US demand for wheat is stronger, terms of trade will be close to US price ratio.

• This can be explained with the help of offer curve. The offer curve shows the quantities of good X that country A supplies to the world market for export and the quantities of good Y that it demands from the world market as imports, for all prices.

Wheat Wheat

India(Wheatexports)

50 90 Auto

export=50A, import=20W

30 60 Auto

export=50W, import=30A

1A=.7w60

20 1A=.4wM

90

50

1w=.6A 1W=.7A

M

O

A

O

T

OA = U.S.A. Offer Curve ; OP = USA Cost Ratio of AutoOB = India Offer Curve ; OQ = India Cost Ratio of WheatOT = Equilibrium Terms of Trade

P

TU.S.A. (Wheat imports)

Q

B

Wheat

Auto

E

A

B

T

P

Q

K

RCost ratio within U.S.A. is KS unit of Wheat and OK unit of auto but it gets KE unit of wheat through trade. The gain of U.S.A = ES unit of wheat

Cost ratio within India is KR unit of Wheat and OK unit of auto but it import OK unit of Auto from U.S.A. in exchange for only KE unit of wheat. The gain of India = ER unit of wheat

O

S

F

REAL INCOME APPROACH

• Instead of importing goods from abroad, if the same are produced and consumed within the country, then the relative loss suffered by the country will constitute the basis for measuring gains from trade. This would be maximum gains.

• On the other hand, if the goods received from international trade are consumed in same ratio as when the same are produced with in the country, then the resulting increase in income will be the minimum gains from trade.

• Real gains from trade is always between these maximum and minimum gains.

MODERN APPROACH

Modern Theory divides the gains from trade into gains from production and gains from consumption.

The theory states that the introduction of trade permits the realisation of gain from exchange and gain from specialisation.

Both consumers and producers gain from international trade by consuming more and producing more than the pre-trade level.

The following diagram shows the decomposition of trade gains into consumption gains and production gains.

AB = Transformation curve representing supply side. CI0 = Community Indifference Curve showing demand side E = Autarky equilibrium (PP is domestic price ratio).

P1= new price line after trade and steeper than PP.(Y become relatively cheaper C = new consumption point after trade on higher CI1.

The movement fromE to C measures the gain from exchange or consumption gains

E

P

P

A

B

CI0

P1

P2

C

CI1

D

X- Commodity

Y-

Co

mm

od

ity

Since the price of X has increased in world market, producers increase its production and decrease that of Y.

This leads to movement along the transformation curve from point E to N where international price line P2 is tangent to AB at N

E

P

P

A

B

CI0

P1

P2

C

C`

N

CI1

CI2D

K

X- Commodity

Y-

Co

mm

od

ity

The new term of trade ratio P2 is the same as P1 because it is parallel to P1. At N the country export NK of X in exchange of KC` imports of Y

Consumption moves from point C to C`. This Movement from C to C` measures the gains from specialisation in production

Hence the gains from international trade are maximised at points N and C` because the MRT in production and MRS in consumption are equal at international price ratio P2.

The total gains from trade is the sum of consumption and production gains and is shown as improvement in welfare from CI0 to CI2.

SIZE OF THE COUNTRY AND GAINS FROM TRADE

Gains from trade are relatively larger for a small country.

Owning to small size, the scope of gains from specialisation and exchange are limited whereas large country has scope for both.

Trade provide an opportunity for the small country to specialise in the production of those commodities in which it has comparative advantage and exchange them in world market.

The more world market prices differ from domestic market, more will be its gains.

IMPORTANT QUESTIONS

What do you mean by ‘gains from trade’ ?

How are the gains from trade are measured?

Discuss the relationship between ‘gains from trade’ and ‘terms of trade’?

What are the kind of gains from trade?

What are the sources of gains from trade?

What are the factors affecting gains from trade?

REFERENCES

M.L. Jhingan, “International Economics” Konark Publication, New Delhi.

M. C. Kemp, “The Gains from Trade and the Gains from Aid: Essays in International Trade Theory” Routledge.

Samuelson, Paul A. (1962), "The Gains from International Trade Once Again," The Economic Journal 72, pp. 820-829.

T.R. Jain, O.P. Khanna and Vir Sen “Development and Environmental Economics and International Trade” V.K. Publications, New Delhi.