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Gains from Trade September 13, 2011

Posted by Chetan Chitre in International Business Management, International Trade Theory.
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Various theories of International Trade explain why trade takes place between countries. These gains from trade can be broadly divided into two types –

(a)    Static Gains and

(b)   Dynamic Gains

Static Gains 

Static means a stationary state. So we are interested in the immediate effect of the trade.

Thus, Static gains are the immediate gains accruing to parties directly affected by trade. i.e. gains accruing (i) to the producing sector of the commodities that are being traded and (ii) to the consumers of these commodities in both countries.

These gains can be further summarized as –

(i) The exporting sector in both countries gain on account of –
(a) increased market size,
(b) opportunity to exploit increasing returns to scale
(c) higher profitability
(d) higher level of employment.

(ii) The consumers in both countries gain as –
(a) Quantity of world production of the traded commodities increases
(b) This leads to a fall in prices
(c) Thus increasing consumer welfare.

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This can be represented by the following diagram –

Assume –

(a) There are two commodities, Bread and Cloth

(b) Curve PP1 is the Production Possibility Frontier representing various combinations of Bread and Cloth that can be produced given certain fixed quantity of resources.

(c) Curves IC1, IC2 and IC3 are indifference curves. Each of these curves represent various combinations of Bread and Cloth, which when consumed will result in exactly the same level of satisfaction for the consumer. Further, higher indifference curves represent higher levels of satisfaction for the consumer. This satisfaction level of a consumer is higher at IC2than at IC1 and so on.

(d) YY1 is a line indicating the ratio of prices of Bread and Cloth in India.

(e) Under conditions of NO TRADE the economy is at equilibrium at point E. Here the rate of substitution between the two commodities for the producer (Marginal Rate of Technical Substitution) is equal to the rate of substitution for the consumer (Marginal Rate of Substitution) which in turn is equal to the ratio of prices of the two commodities.

(f) At this point the production and consumption of Bread is OB while the production and consumption of Cloth is OD

(g) In case there is trade with the outside world, the slope of the price line changes as internationally prevailing prices now have an effect on local prices.

(h) Assuming that internationally the price of cloth is higher than that in local economy while the price of bread is lower, the price line shifts to XX1.

(i) With the new set of prices, the consumer equilibrium shifts to point H. Note that point H is on a higher Indifference Curve thus indicating that the level of satisfaction of the consumer has increased.

(j) The producer shifts his equilibrium to point G.

(k) Note that with the new set of prices at XX1, and consumers’ and producers’ equilibrium at H and G respectively, the total production of Bread in the economy has come down to OC while the consumption of Bread has increased to OA. Thus AC quantity of Bread is imported.

(l) A similar explanation can be given in case of Cloth.

(m) Thus the total gains from trade to the economy can be summarized as – (i) The consumer moves to higher Indifference Curve thus to a higher level of satisfaction. (ii) The Cloth sector expands thus giving the sector greater opportunities to people involved in that sector.

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These are the Static gains from Trade.

Gains from trade depends upon –

(a)    Comparative Cost Advantage – Comparative costs advantage enjoyed by a country in production of certain commodity sets upper limit to the maximum gains from trade.

(b)   Reciprocal Demand – Demand for exported commodities in foreign country and demand for imported commodity in domestic market determines the exact level of gains from trade.

(c)    Elasticity of Demand – If price-elasticity of demand for exported commodity is low and for imported commodity is high, the gains from trade are likely to be high.

(d)   Income elasticity of Demand – If Income elasticity of demand for exported commodities is high, the gains from trade are likely to high.

(e)   Employment intensity of exported sector, if high, leads to higher gains from trade.

Dynamic Gains from Trade 

Dynamic Gains from Trade accrue to a country over longer period of time. The sectors involved in trade are the ones that are directly affected by trade are the first to experience positive effects. Over a period of time these positive effects spread in other sectors as well, gradually impacting the entire economy. These are referred to as the Dynamic Gains From Trade.

Examples of Dynamic Gains from Trade can be –

(1)    Increase in National Income – Trade leads to an increase in National Income. Domestic consumption level may be limiting the production potential of the economy. Opening the economy to foreign trade brings in additional demand in the form of export demand, thus increasing the level of National Income.

(2)    Increase in level of employment – Increase in level of Aggregate Demand on account of exports leads to rise in levels of GDP and thus increase in employment levels.

(3)    Increase in overall standard of living –International trade leads to equalization of factor prices (factor prices in different countries gradually get equalized on account of international trade) Trade also leads to a downward pressure on general price levels as commodities which are available cheap in other countries can be imported. All this leads to a rise in standard of living of the population.

(4)    Increase in overall productivity of the national economy – Products that are produced using advanced technology are imported. Domestic producers try to compete with these products, leading to more investment in R&D. This leads to overall rise in productivity of the economy.

(5)    Increase in investments – Investments rise to take advantages of the additional opportunities that arise on account of foreign trade. The spillover effect of foreign trade, such as rise in aggregate demand leads to increase in overall level of investment.

(6)    Terms of Trade move in favor of domestic economy – Gains of Trade can be measured using the concept of Terms of Trade. Gains from trade lead to Terms of Trade moving in favor of the domestic country.

(7)    Improvement in balance of Payment Situation – Long Term gains from trade leads to an increase export earnings of an economy, thus leading to a sustained improvement in the Balance of Payments position.

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