CHAPTER
14.1
14
GAINS
FROM
TRADE
Introduction Of Absolute & Comparative Advantage
A. Absolute advantage
A country is said to have an absolute advantage in producing a good if it can produce
of a good with the
amount of resources.
E.g
Food(F)
Clothing(C)
Country A
10
OR
6
Country B
5
OR
10
 Country A has an absolute advantage in producing
Country B has an absolute advantage in producing
.
.
B. Comparative advantage
A country is said to have a comparative advantage in producing a good if it can
produce that good at a lower
than other countries.
E.g.
Machine(M)
Bread(B)
Country X
10
OR
20
Country Y
9
OR
10
 Country
has absolute advantage in producing both M and B. But it only
has comparative advantage in producing
only. The other country has
comparative advantage in producing
.
14.2
The Model Of Absolute Advantage & The Model Of Comparative Advantage
A. The model of absolute advantage (Reciprocal absolute advantage) (p.248)
If one country has absolute advantage on one good and the other country on the other,
then each country should specialize in producing the good in which it has
absolute advantage and then trade. They are able to enjoy a
level of
output than before.
Refer to the example on p.248
Q. If there is no reciprocal absolute advantage, e.g. Country A has absolute
advantage in both F and C, then no trade will be possible ?!
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B. The model of comparative advantage (p.250)
If each country specializes in producing the good (or range of goods) in which it has
opportunity cost compared to other countries and then trades with other countries,
it is able to enjoy a level of output higher than that which it would have if it
attempted to be self-sufficient.
Refer to the example on p.250
14.3
Graphic Analysis Of International Trade (p.259)
We can illustrate the gains from trade by using PPC.
Constant cost is assumed  PPC is a
line (i.e., constant slope).
A. The model of absolute advantage (Reciprocal absolute advantage)
Refer to fig.1 on p.259
Notes : (i) For each country, some consumption bundles which are not attainable
before are now attainable with s
and t
.
(ii) Terms of trade (TOT) curve is also the consumption possibility curve
(CPC).
B. The model of comparative advantage
Refer to fig.2 on p.261
Q. If other information e.g. labour requirements for producing goods are given,
how to discover the comparative advantage?
Refer to the case on p.253
14.4
The Terms Of Trade (TOT)
(p.254)
A. The meaning
(i) It means the amount of goods that a country must give up (export) to get one
unit of imported good.
E.g. 1F can be exchanged for 2C.
That means if a country import F, TOT =
if a country import C, TOT =
But in fact, we usually express like this 1F : 2C .
(ii) TOT simply represents the
of obtaining goods through
international trade.
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(iii) However, it is customary in official government statistic to define TOT in
another way.
TOT =
x 100
Hence, as TOT rises  TOT is improved (it is a favourable change).
As TOT falls  TOT is deteriorated (it is an unfavourable change).
Note:
An improvement or deterioration of the TOT does not necessarily mean
that a country is better off or worse off.
It may be that (a) productivity is improved  Px
 TOT
But improved productivity is a good thing to the country.
(b) better quality of imports  Pm
 TOT
But, of course, the country is not necessarily worse off!
Exercise 1
“When TOT rises, the balance of trade (BOT) rises, too.” Is this correct? Why?
B. Mutually beneficial TOT
(i) Both countries will gain from trade if the TOT lies between the domestic
opportunity cost or exchange ratios of the 2 countries.
E.g. The domestic cost or exchange ratio of the 2 countries in the example
provided in the textbook is :
Food(F)
Country A
0.6C
Country B
2C
That means :
A’s cost in producing 1F is
exchange
B’s cost in producing 1F is
in exchange
 TOT :
< 1F <
Alternatively,
B’s cost in producing 1C is
exchange
A’s cost in producing 1C is
in exchange
 TOT :
< 1C <
Remark :
(i) The potential gain in the above case is
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Clothing(C)
1.67F
0.5F
 it minimum gets
in
 it maximum forgoes
 it minimum gets
 it maximum forgoes
C or
F  if the
in
transaction cost is greater than
C or
F, no trade will take place.
(ii) The distribution of the gains from trade determined by TOT which in turn
depends on the
of the 2 trading countries.
14.5
Assumption Behind The Trade Models, Other Gains From Trade & Some
Remarks
A. Assumptions
Refer to p.255
B. Other gains from trade
Refer to p.256
C. Remarks
Refer to p.258
14.6
Trade Models With Increasing Cost Of Production
Because of specialization  transfer resources to produce a specific good 
returns to scale will eventually set in  relative cost in producing
that good changes  lose comparative advantage
So, we need trade models with increasing cost of production.
A. Trade model with only 2 countries (p.263)
Consider : 1 good (good X), 2 demand and supply curves (of exporting and importing
countries).
P
S=MC
P
D
S=MC
D
0
-
Q
0
Q
are equilibrium P and Q under self-sufficiency in A and B
respectively.
- Cost and use value at the marginal unit are different (
,
).
- MC and MUV in country A is
than those of B  A is an
of good X and B is the
.
- Pe must be at a level at which the amount of
= the amount of
If they are unequal, equilibrium price will change until they are equal.
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Q. What are the gains from trade?
Ans. There are 2 sources of gains : (p.264)
(i)
gains
It comes from reallocating consumption from the country with
MUV to the country with
MUV.
(ii)
gains
It comes from reallocating production from the country with
the country with
MC.
P
S=MC
MC to
P
D
S=MC
D
0
Q
0
Q
Continue the example above,
(a) gains to Country A
(i) increase consumption by
 the UV from consuming
than the cost in obtaining them (i.e., area
)
is
(ii) decrease production by
 save in production cost is
than the cost of purchase (i.e., area
)
(b) gains to Country B
(i) decrease consumption by
 the loss of UV from consuming
is
than the receipts from selling them (i.e., area
)
(ii) increase production by
 the extra production cost is
than the receipts from selling (i.e., area
)
B. Trade model in a price-takers’ market (p.265)
Large no. of countries in the international market  any shifts in domestic demand
and supply will lead to changes in quantity imported and exported, but
will remain unchanged.
C.
Analysis with PPC ( 1 country, 2 goods )
(i) With increasing cost  PPC is
(ii) PPC = CPC when there is no
(p.265)
to the origin.
.
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good Y
0
Example :
At point A, there is no trade.
good X
Slope of the straight line (TOT) represents Q of good
that can be
exchanged for 1 unit of good
in the international trade.
Slope at point A is
than that of the straight line. That means, cost of
producing good X is
than the cost of exchanging good X in the
international market.
 reducing production of good
and exchange good
for
in the open market.
 this process continues until the cost of producing good
by
itself = the cost of exchanging it in the international market (i.e.,
point B).
With trade, moving away from B along the straight line until a higher IC is
reached (i.e., IC2)
Vertical difference between point B and C is
and the horizontal
difference between point B and C is
.
Q. Can you work out the reverse case yourself?
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