The Gains from Trade (An Overview)

The below mentioned article provides an overview on the gains from trade.

Nations—developed or underdeveloped- trade with each other because trade is mutually beneficial. In other words, the basic motivation of trade is the gain or benefit that accrues to nations.

In the case of autarky or isolation, benefits of international division of labour do not flow between nations. It is advantageous for all the countries of the world to engage in international trade. However, the gains from trade can never be same for all the trading nations. Some countries may reap a larger gain compared to others. Thus, gains from trade may be inequitable but what is true is that “some trade is better than no 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.

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.

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.

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.