Gains from Trade, Terms of Trade, Trade Multiplier | UGC NET Economics – Notes

Gains from Trade

Meaning of Gains from Trade

• Gains from international trade refer to the various benefits which a country derived by way of trading of goods and services with other countries. Such benefits from trade are because of international division of labour and specialisation. Countries trade with each other because trade is beneficial to all. The basic motivation of trade is the gain or benefit that nations accrue over the period. Each trading country gains when the total output increases as a result of the division of labour and specialisation. In the case of autarky or isolation, the benefits of the international division of labour do not flow between nations.

• Malthus held that ‘the gain from trade consisted of the increased value which results from exchanging what is wanted less for what is wanted more’, and that ‘international trade, by giving us commodities much better suited to our wants and tastes than those which had been sent away, has decidedly increased the exchangeable value of our possessions, our means of enjoyment, and our wealth’.

• In simple words, gains from trade refers to additional production and consumption effects that countries can achieve by way of entering trade with each other. To sum-up, gains from international trade are of two types:

  • Gain from exchange

  • Gain from specialisation in production

• Approaches preferred by various economists will be discussed in subsequent sections.

Sources of Gains

• As per the classical theory, the major source of gains from international trade arises out of specialisation based on the principle of comparative cost advantage. While pointing out the ‘division of labour’, Adam Smith held that it is limited by the size of the market. Upon expansion of the market size because of international trade, the scope for large-scale production also increases, which in turn increases the scope for complex division of labour and specialisation. In short, international trade leads to enlargement of the market, which further leads to specialisation and division of labour. This process further results in an increase in output per unit of input.

• The comparative cost theory exhibits increased world production as gains from international trade in the real-world scenario. Each trading country gains by way of getting relatively more, better and cheaper goods. In the entire process, no country loses by having less than what they needed.

• In this way we can say that gains from trade are the results of specialization in production from the division of labour, economies of scale, and agglomeration along with the relative availability of factor resources.

• When there is free trade, goods and services produced all over the world are available to people everywhere. In other words, international trade makes available to the people of a country, a galaxy of goods and services at the most competitive prices. A country may not have the factor endowments or technological capability to produce certain goods. If there is no trade with other countries, it will have to do without such goods, but through international trade, it can procure them.

• The gains from international trade may be summed up as follows:

  • Expansion of the size of the market.

  • Division of labour.

  • Gains from specialisation.

  • Gains from increased product variety.

  • Gains from competition.

  • Gains from increased economies of scale.

  • Productivity gains.

Factors Determining Size of Gains

• Differences in cost ratios: If Country A has a comparative advantage in the production of wheat and Country B has a comparative advantage in the production of cotton, both countries will gain from trade. The size of the gain will depend on the cost of production of each commodity in both countries. The gain from international trade depends upon the cost ratios or differences in comparative cost ratios in the two trading countries. The larger the difference between the exchange rate and the cost of production, the larger the gains from trade, and vice versa.

• Reciprocal demand: The reciprocal demand means the relative strength and elasticity of demand of one country for the product of the other in exchange for its product.

• Level of income: The level of money income of a country is another factor which determines the gains and the share of trade. A country whose goods have constant demand in other countries will have a high level of money income.

• Terms of trade (also called “trading price”): It is the most important factor which determines the gains from trade. The international terms of trade refer to the rate at which one commodity of a country is exchanged for another commodity of the other country. If the cost ratio and terms of trade are closer to each other, more will be the gains from the trade of the participating countries.

• Productive efficiency: An increase in the productive efficiency of a country also determines its gains from trade. It lowers the costs of production and prices of goods in the home country. As a result, the other country gains by importing cheap goods and its terms of trade improve.

• Nature of commodities exported: Another factor is the nature of commodities exported by a country. A country that exports mainly primary products has unfavourable terms of trade. Consequently, its gains from trade will be smaller. On the contrary, a country exporting manufactured goods has favourable terms of trade, and its gains from trade will be larger.

• Technological conditions: In a country which is technologically advanced and has an abundance of capital, its volume of foreign trade will be large and so it will gain from international trade. On the other hand, if a country is technologically backward with abundant labour, its volume of foreign trade will be small and so will be its gains from trade.

• Size of the country: If a country is small, it is relatively easy for it to specialize in the production of one commodity and export the surplus production to a large country and can get more gains from international trade. Whereas if a country is large, then it must specialise in more than one good because the excess production of only one commodity cannot be exported fully to a small-sized country as the demand for the commodity will reduce very frequently. So, the smaller the size of the country, the larger the gains from trade.

• Factor availability: International trade is based on specialization, and a country specializes depending upon the availability of factors of production. It will increase the domestic cost ratios and thereby the gains from trade.

• Productive Efficiency: An increase in the productive efficiency of a country also determines its gains from trade. A highly efficient country can keep the cost of production and price of the goods lower than other countries.