Topic #6: The Gains from Trade

Dr David Penn

Associate Professor of Economics and Director of the Business and Economic Research Center

Gains from Trade

Importance of specialization Comparative advantage Economic growth by trade Absolute advantage

Gains from Trade in Economic History

Adam Smith (1776) Trade allows us to specialize Specialization makes us more productive

David Ricardo (1816) Countries should trade based on their comparative

advantage Even when one country is more productive than the

other, trade can benefit both.

Gains from Trade Model

Model: Two countries: U.S. and Brazil Two goods: large jets and small jets Simplifying assumption: the

production possibilities frontier is linear (constant opportunity costs)

Gains from Trade Argument

Compare consumption of large jets and small jets in two scenarios:1) No trade between the U.S.

and Brazil2) U.S. and Brazil engage in

trade Does total consumption

increase when the two countries engage in trade?

Gains from Trade

U.S. production possibilities frontier with no trade:

Large jets

Small jets40

30

The U.S. consumes 18 large jets and 16 small jets with

given resources.

18

16

The opportunity cost of one small jet for the U.S. is ¾ of

a large jet.

Gains from Trade

Brazil’s PPF with no Trade:

Small jets30

10

6

8

Brazil consumes 8 large jets and 6 small jets.

Large jetsThe opportunity cost of one small jet for Brazil is 1/3 of a

large jet.

Comparative Advantage and Opportunity Cost

Gains from trade arise from comparative advantage.

Comparative advantage depends on differences in opportunity costs, not production costs.

Countries with differing opportunity costs will gain from trade, even if one country is more productive than the other.

Opportunity Costs

What is the opportunity cost of producing 1 small jet? Brazil: 1/3 of a large jet U.S.: ¾ of a large jet Conclusion: Brazil is the low cost producer of small

jets since its opportunity cost is lower. Brazil has a comparative advantage in small jets.

Opportunity Costs

What is the opportunity cost for producing 1 large jet? Brazil: 3 small jets U.S.: 4/3 of a small jet Conclusion: the U.S. is the low cost producer of

large jets since its opportunity cost is smaller. The U.S. has a comparative advantage in large jets.

Gains from Trade Both countries should specialize in production

according to their comparative advantage. Consequently, the U.S. should produce more

large jets and Brazil should produce more small jets.

Then the two countries should trade to obtain the other type of jet.

Gains from Trade After specialization:

U.S. production: 30 large jets and 0 small jets Brazil production: 0 large jets and 30 small jets

Then both countries engage in trade.

Trade With no trade, both countries must consume

only what they produce. With trade, both countries may specialize and

trade for the other good. With trade, both countries benefit from

comparative advantage.

Gains from Trade Results

• With no trade, both countries can only consume what they produce.

No TradeProduction

and Consumption

U.S. Large jets 18Small jets 16

Brazil Large jets 8Small jets 6

Gains from Trade Results

• With trade, each country specializes according to its comparative advantage.

• Suppose each country produces only one type of jet according to comparative advantage and trades for the other type of jet.

Comparative advantage & opportunity costs (again)

U.S. Opportunity

Cost

Brazilian Opportunity

CostOne small jet 3/4 large jet 1/3 large jetOne large jet 4/3 small jets 3 small jets

• Suppose the U.S. can trade for 2 small jets in exchange for 1 large jet. The U.S. benefits. (why?)

• Suppose Brazil can trade 2 small jets for one large jet. Brazil benefits.

Gains from Trade Results

• When trading 2 small jets for one large jet both countries benefit. These are the terms of trade.

• Other mutually beneficial terms of trade are possible.

Gains from Trade Results

• The terms of trade are 2 small jets in exchange for one large jet.

• Both countries can consume more of both types of aircraft with trade compared with no trade.

No TradeProduction

and Consumption Production Consumption

Gains from Trade

U.S. Large jets 18 30 20 2Small jets 16 0 20 4

Brazil Large jets 8 0 10 2Small jets 6 30 10 4

With Trade

Gains from Trade

U.S. production possibilities frontier with trade

Large jets

Small jets40

30

U.S. consumption with no trade18

16

20

20

U.S. consumption with trade

Gains from Trade

Brazil’s PPF with Trade:

Small jets30

10

6

8

Brazilian consumption with no

trade.

Large jets

Brazilian consumption with trade.

10

Summary

• Two important points:• 1) The gains from trade model shows that with

specialization and trade, countries can consume more than if they were self-sufficient.

• 2) Every country (and every person) has a comparative advantage in something (and therefore a comparative disadvantage in something else.)