gains from trade theory

8/17/2019 Gains From Trade Theory

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The Law of Comparative Advantage

According to the law of comparative advantage, even if one nation is less efficient than the other

nation in the production of both commodities, there is still a basis for mutually beneficial trade.

The first nation should specialize in the production and export of the commodity in which its

absolute disadvantage is smaller and import the commodity in which its absolute disadvantage is

greater.1

1 Source: Salvatore, D., !1", #nternational $conomics 11th edition. p. "%


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Illustration Of The Gains From Trade Using A Single Country

Assume that a country produces two goods, & and ', in a closed economy. (igure 1 illustratesthe production possibility frontier of this country with the relative commodity price line in blue

which is tangent to the community indifference curves and the ))(. The point of autar*y is at

+&1, '1 where the country produces and consumes &1 units of good & and '1 units of good '.

(igure 1- A closed economy


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ow suppose that the economy is open for trade and the price of good ' is lower internationally

but the price of good & remains the same. This increases the slope of the relative commodity

price line and allowing the country to attain higher levels of consumption on a higher community

indifference curve. Since good & is now relatively cheaper to produce domestically than good ',

the country can trade some of good & for good '. This is illustrated in (igure below. /ith

domestic production still at +&1, '1, after trading, consumption will be at the point +&, '.

The country will export +&1 0 & units of good & and import +' 0 '1 units of good '

enabling it to achieve a higher welfare reflected by the higher indifference curve at point +&,

'.

(igure - $ffects of an open economy.


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Since this country has a comparative advantage in the production of good &, specialization and

trade will allow even greater gains to be made. (igure " illustrates how specialization and trade

can further increase the countrys welfare. /ith specialization in good &, the country now

reduces production of good ' from '1 to '2 in order to increase production of good & from &1

to &2. The country can now trade +&2 0 &" units of good & through exports in return for +'" 3

'2 units of good ' through imports. /ith domestic production at the point +&2, '2,

international trade allows the country to attain a higher level of consumption at the point +&",

'". As compared to (igure 1 with no trade and specialization, there is an overall increase in

consumption of good ' by +'" 3 '1 and an increase in the consumption of good & by +&2 3

&". This shows how a country can gain from trading by specializing in the good of its

comparative advantage and exchanging some of that good for the good of its comparative

disadvantage.

(igure "- 4ains from trade with specialization.

gains from trade theory

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