Trade

• In simple words, gain from trade refers to extra

production and consumption effects that countries can
achieve through international trade. These gains are,
thus, of two types gain from exchange and gain from
specialisation in production.
• The idea of gains from trade was at the core of the
classical theory of international trade propounded by
Adam Smith and David Ricardo. According to Smith, the
gains from trade arise form the advantages of division of
labour and specialisation—both at the national and
international level. Such advantages arise, according to
Smith, due to the absolute differences in costs.
Ricardo goes a step further. He says that
trade contributes “to increase the mass of
commodities, and therefore, the sum of
enjoyments…” Ricardo adds that the gain
from trade consists in the saving of cost
resulting from obtaining the imported
goods through trade instead of domestic
production.
At the final TOT, goods demanded by one country
are equal to the goods demanded by the other, or
one country’s supply or the export of good must
equal the other country’s demand for that good.
Thus, TOT is an index of measuring a country’s gain
from trade. As a result, if a poor, small, less
developed country (LDC) trades with a large, rich,
developed country’s (DC) autarkic or domestic cost
ratio, then the LDC will acquire all the gains from
trade. If the actual TOT lies between two domestic
cost ratios then gains from trade will accrue to both
the countries.
• Ricardo’s comparative cost thesis may be applied to establish the
existence of gains from trade. In other words, gain from trade
depends on the comparative cost conditions. Comparative cost
doctrine suggests that trade can provide benefit to all countries if
they specialise in the production of those goods and, hence, export
them in which they have comparative advantage.
• A country, thus, specialises in production and export in accordance
with its comparative advantage. Ricardo’s trading nations acquire
complete specialisation in production. As a result, global output
becomes larger than under autarky. Trade also enables each
country to consume more than under isolation. Thus, there is a
production gain and a consumption gain arising out of international
trade. Such gains cannot be reaped in the absence of trade.
However, in determining the exact volume of gains from trade,
Ricardo’s doctrine is incomplete. For this, what is required is the
determination of the actual terms of trade or exchange rate at which
trade would take place. The rate at which one commodity (say, export
good) is exchanged for another commodity (say, import good) is called
terms of trade. Or what import the export buys is called the TOT. Of
course, export (and, hence, import) varies with the change in TOT.
• This concept of TOT was introduced in the literature by J. S. Mill by
introducing the concept of reciprocal demand. By reciprocal
demand we mean demand of each country for the other’s goods.
On the basis of the principle of reciprocal demand, Mill determined
a final TOT at which trade between two nations takes place.
However, gains from trade depend on
the :
• i. Relative strengths of elasticity of demand for
export and import of goods;
• ii. Size of the country;
• iii. Changes in technology;
• iv. Supply of goods traded; etc.
• In general, greater the inelasticity in the foreign
demand for exports and greater the elasticity of
foreign demand for imports, greater will be the
gains from trade.
Further, trade leads to increased competition. Competition
enhances efficiency LDCs gain largely in this competitive
world. Improved research and technology of the developed
world flow in these countries. Openness to trade supports
technological upgrading via learning. Evidence on learning and
technological up gradation is observed in many activities,
mainly in the manufacturing and service sectors.
• Larger output and productivity increases indeed can occur
not only in the manufacturing sector, but also in other
sectors in which technological upgrading of the advanced
countries is embodied. In addition, variety of products
becomes available to consumers. All these suggest that
trade is an ‘engine of growth’.
• However, gains from trade can never be
unambiguous for all the countries. Sometimes,
TOT may turn adverse against poor LDCs. Further,
trade policy is often designed by the advanced
countries in such a way that it reduces benefits of
the LDCs from trade. Possibly, due to this fact it is
said that free trade is better than restricted trade.
Of course, restricted trade has merits too. By
imposing a tariff, a poor country can even
improve its TOT and, hence, can obtain benefits
from trade.
Absolute advantage and comparative
advantage are two important concepts
in international trade that largely influence how
and why nations devote limited resources to the
production of particular goods. They describe
the basic economic benefits that countries get
from trading with one another.
 Absolute Advantage
Though it is not economically feasible for a
country to import all of the food needed to
sustain its population, the types of food a
country produces can largely be affected by the
climate, topography and politics of the region.
Spain, for example, is better at producing fruit
than Iceland. The differentiation between the
varying abilities of nations to produce goods
efficiently is the basis for the concept
of absolute advantage.
 Comparative Advantage
The focus on the production of those goods for
which a nation's resources are best suited is
called specialization. When economists refer
to specialization, they mean the increase in
productive skill that is achieved from focused
repetition in producing a good or service. A country
specializes when its citizens or firms concentrate
their labor efforts on a relatively limited variety of
goods. Historically, specialization arose as a result of
different cultural preferences and natural resources.
 Implications of Comparative
Advantage
• Consider a hypothetical situation where the U.S.
can either produce 100 televisions or 50 cars.
China can produce 50 televisions or 10 cars. The
U.S. is better at producing both in an absolute
sense, but China is better at producing televisions
because it only has to give up one-fifth of a car to
make one television; the U.S. has to give up one-
half of a car to make a television. Conversely, the
U.S. only has to trade two televisions to make a
car, while China has to forgo five televisions to
make a car.
 The Bottom Line
Comparative advantage leads to
more income for countries. It's a key argument
in favor of free trade. By comparison,
restrictions on trade in the form
of tariffs or quotas skew comparative
advantages. The result is products that should
have been imported become more expensive
and resources are wasted on activities that don't
produce the highest return.