Gains From Trade

Gains from Trade Measures

Gains from trade measure how much countries gain when they engage in international trade. To measure this, we need to understand that not every country will be good at producing every good. Some countries will have advantages over others due to their climate, geography, natural resources, or established infrastructure.

When one country is better at producing a good than another, they have a comparative advantage in producing that good. We measure a country's production efficiency by taking a look at the opportunity cost they incur by producing the good. The country that has a lower opportunity cost is more efficient or better at producing the good than the other. A country has an absolute advantage if it can produce more of a good than another country using the same level of resources.

When two nations decide to engage in trade, they will establish who has the comparative advantage when producing each good. This establishes which nation has a lower opportunity cost when producing each good. If a nation has a lower opportunity cost for producing Good A, while the other is more efficient at producing Good B, they should specialize in producing what they are good at and trade their excess with each other. This makes both nations better off in the end because they both maximize their production and still benefit from having all the gods that they want. The gains from trade are this increased benefit that both nations experience because they engage in trade.

Gains from Trade Formula

The gains from trade formula is calculating the opportunity cost for each nation to produce a good, seeing which nation had the comparative advantage for producing which goods. Next, a trading price is established that both nations accept. In the end, both nations should be able to consume beyond their production capabilities. The best way to understand is to work through the calculations. Below in Table 1, we see the production capabilities for Country A and Country B for shoes versus hats per day.

To calculate the opportunity cost each nation faces when producing each good, we need to figure out how many hats it costs each nation to produce one pair of shoes and vice versa.

To calculate the opportunity cost of producing hats for Country A, we divide the number of shoes by the number of hats produced:

\(Opportunity\ Cost_{hats}=\frac{25}{50}=0.5\)

And for the opportunity cost of producing shoes:

\(Opportunity\ Cost_{shoes}=\frac{50}{25}=2\)

We can see in Table 2 that Country A has a lower opportunity cost when producing hats, and Country B does when producing shoes.

This means that for every hat produced, Country A only gives up 0.5 pairs of shoes, and for every pair of shoes, Country B only gives up 0.67 hats.

It also means that Country A has a comparative advantage when producing hats, and Country B does when producing shoes.

If the two countries do not trade, Country A will produce and consume 40 hats and 5 pairs of shoes, while Country B will produce and consume 10 hats and 30 pairs of shoes.

Let's see what happens if they do trade.

Table 3 shows us that if the countries decide to trade with each other, they will both be better off because they will both be able to consume more goods than they could before they traded. First, they have to agree on terms of trade, which in this case will be the price of the goods.

To be profitable, Country A must sell hats at a price higher than its opportunity cost of 0.5 pairs of shoes, but Country B will only buy them if the price is lower than its opportunity cost of 1.5 pairs of shoes. To meet in the middle, let's say that the price of one hat equals one pair of shoes. For every hat, Country A will get one pair of shoes from Country B and vice versa.

In Table 3, we can see that Country A traded nine hats for nine pairs of shoes. This made it better off because now it can consume one hat and four extra pairs of shoes! This means that Country B also traded nine for nine. It can now consume one extra hat and three extra pairs of shoes. The gains from trade are calculated as the difference in quantity consumed before engaging in trade and after trading.

Gains from Trade Graph

Looking at the gains from trade on a graph can help us visualize the changes that occur along both countries' production possibilities frontier (PPF). Both nations have their respective PPFs that show how much of each good they can produce and at what ratio. The goal of trading is to have both nations be able to consume outside of their PPFs.

Fig. 1 - Both Country A and Country B receive gains from trade

Figure 1 shows us that the gains from trade for Country A were one hat and four pairs of shoes, while Country B gained one hat and three pairs of shoes once it started trading with Country A.

Let's start with Country A. Before it started trading with Country B, it was producing and consuming at point A on the PPF marked Country A, where it was only producing and consuming 40 hats and 5 pairs of shoes. After it began trading with Country B, it specialized by only producing hats at point A_P. It then traded 9 hats for 9 pairs of shoes, allowing Country A to consume at Point A¹, which is beyond its PPF. The difference between point A and point A¹ is Country A's gains from trade.

From County B's perspective, it was producing and consuming at point B before engaging in trade with Country A. It was only consuming and producing 10 hats and 30 pairs of shoes. Once it began trading, Country B started producing at point B_P and was able to consume at point B¹.

Gains from Trade Example

Let's work through a gains from trade example from start to finish. To simplify, the economy will consist of John and Sarah, who both produce wheat and beans. In one day, John can produce 100 pounds of beans and 25 bushels of wheat, while Sarah can produce 50 pounds of beans and 75 bushels of wheat.

We will use the values from Table 4 to calculate each person's opportunity cost of producing the other good.

From Table 5, we can see that Sarah has a comparative advantage when producing wheat, while John is better at producing beans. When Sarah and John are not trading, Sarah consumes and produces 51 bushels of wheat and 16 pounds of beans, and John consumes and produces 15 bushels of wheat and 40 pounds of beans. What would happen if they started trading?

Table 6 shows that engaging in trade with each other is beneficial to both Sarah and John. When Sarah trades with John, she gains an extra bushel of wheat and 29 pounds of beans. As for John, he gains an extra pound of beans and an extra 4 bushels of wheat.

Fig. 2 - Sarah and John's gains from trade

Figure 2 shows how Sarah and John benefited from trading with each other. Before the trade, Sarah was consuming and producing at point A. Once she started trading, she could focus on producing at point A_P and be able to consume at point A¹. This is significantly outside of her PPF. As for John, before, he could only produce and consume at point B. Once he started trading with Sarah, he could produce at point B_P and consume at point B¹, which is also significantly above his PPF.