Question

What are the major forces (hint: exchange and specialisation) that determine the gains from trade for trade partners? Explain and possibly illustrate with diagrams.

Answer 1

FORCE 1 : Terms of Trade:

The terms of trade refer to the rate at which the commodity of one country is exchanged with the commodity of the other country. The terms of trade have the most significant influence on the size of gain from trade of a country. More favourable the terms of trade, larger may be the gains from trade. If a country has unfavourable terms of trade, it does not mean that the country derives no benefit from trade.

It simply implies that the share of such a country out of the total gains from trade is relatively smaller. Closer the terms of trade of a country to the domestic exchange ratio of two commodities lesser is the size of gain from trade for it and vice-versa.      

FORCE 2: Differences in Cost Ratio:

The difference in comparative cost ratios of producing two commodities in the two trading countries have much bearing upon the gain from international trade. If country A has comparative cost advantage in the production of cloth and B has cost advantage in the production of steel, they will specialise in these respective goods and make gain from trade. If specialisation results in a relatively greater fall in the cost of cloth in country A than that in steel in country B, greater gain from trade will become available to A and vice-versa.

In the words of R.F. Harrod, “A country gains by foreign trade, if and when the traders find that there exists abroad a ratio of prices very different from that to which they are accustomed at home.” Greater the difference in cost ratio, more is the gain from trade for a country relative to the other.

FORCE 3. Reciprocal Demand:

The reciprocal demand refers to the elasticity of demand for the product of one country by the other country. If the demand for cloth (exportable of A) is less elastic in country B, the latter will offer more quantity of steel for one unit of cloth. It will cause the terms of trade to turn in favour of country A and this country will obtain a greater share from the total gain from trade.

On the opposite, if the demand for steel in country A is less elastic or more intense, the terms of trade will move in favour of B and consequently greater gain from trade will become available to it. A country whose demand for the foreign products is more elastic but the demand for its products from the foreigners is less elastic, is likely to gain the most from international trade.

FORCE 4. Size of the Country:

A small country has a limited size of domestic market. Its productive resources too are limited and specific. The specialisation and exchange within the home country can bring very little benefits for it. As international trade commences, this country may completely specialise in the production of such commodities in which it enjoys comparative advantage over the other countries. The greater the difference between the international price and domestic price of its exported products, greater will be the share out of gain from trade for this country.

A large country, on the opposite, possesses a large domestic market and diversified productive resources. If trade commences, it will have only incomplete specialisation. Since the small country can absorb very small quantity of the product available for export, it will have to dispose of a large part of its product in the home market. It may have substantial gain from specialisation and exchange within the home country but the gain from international trade will be very small.

FORCE 5. Level of Income:

The higher or lower level of money income of a country too determines the gain from trade for it. If the products of the home country command a strong and permanent demand, the expansion in its exports will raise the incomes from exports. The output in these industries will expand and the increased demand for labour will raise the money wages of workers. The employers in other industries will also raise wages to retain their more efficient workers.

Thus there will be an overall increase in money incomes. The import of relatively cheaper commodities, while domestic money incomes are high, signifies the gain from trade. On the opposite, the low domestic money income due to low exports or larger imports from abroad, while import prices are high, will reduce the level of welfare and result in smaller gain from trade.

FORCE 6. Productive Efficiency:

If there is an improvement in the productive efficiency in the home country, the costs and product prices decline. As the foreigners can import commodities from this country at lower prices, the terms of trade go in favour of foreign country. The larger proportion of gain from trade too goes to the latter. An increased efficiency in a foreign country will enable the home country to import goods at relatively lower prices. This will cause an improvement in the terms of trade for the home country and larger share out of gain from trade will become available to the home country.

FORCE 7. Endowments and Technological Conditions:

If a country is capital-abundant and advanced from economic and technological viewpoints, it will have a large volume of foreign trade. Corresponding to the volume of its foreign trade, its share out of gain from international trade is also likely to be larger. On the contrary, the technically and economically backward labour- abundant country will have a small size of foreign trade. The gain from trade for such a country will also be relatively small.

FORCE 8. Nature of Products Exported:

If a country predominately exports the primary products, the terms of trade for it will be unfavourable and the gain from trade for it will be smaller. On the opposite, if the exports of a country are largely of manufactured goods, the terms of trade will be favourable for it. Such a country will obtain a relatively larger share out of the gains from trade.