GAINS FROM INTERNATIONAL TRADE

1. International trade helps to widen the range of choice of goods or products. A country is
able to consume imported products not able to be produced locally due to lack of
knowledge or technology, weather conditions.

2. Allows the transfer of knowledge, technologies and information between trading partners.
Research & development from developed countries can benefit developing countries
through trade.

3. Economic Development :-International trade facilitates economic growth of participating

counties. It acts as a catalyst of growth to developing countries as these countries can
benefits from the transfer of technology and new methods of production from advanced
countries. In addition, trade reduces or removes trade barriers, which in turn reduces the
prices of imported goods and increases the demand in world markets. Increase in demand
leads to higher production, production results in economic growth participating countries.

4. It engenders increased healthy competition because of international trade hence the need
to be efficient and effective in the production. It helps to further stimulate research and
development and more rapid adoption of new technology to reduce costs of production in
order to compete with imported products. WTO and other international forums encourage
trade with less or no restrictions. Thus international trade generates healthy competition
among the firms of different countries across the globe.

5. International trade enables countries to embark on specialization which ultimately

increases world output and improves the standard of living.

6. International trade leads to more efficient resource allocation and lower cost per unit of
output as the market is very much bigger and broader to exercise economies of scales,
etc. Optimum Use And Allocation Of Resources :-Different countries specialises on the
basis of factor endowments which results in maximum production of t hose goods in
which they enjoy comparative cost advantage. Efficiency :-International trade increases
the efficiency of the firms. To remain competitive firms undertake research and
development activities, Training and development and Technology upgradation. This
increases efficiency which in turn increases profits. Thus specialization ensures optimum
use and allocation of resources.

7. Employment :-International trade increases employment opportunities. This leads to

increase in production in participating countries. Increase in production generates more
employment not only in production sector but also in distribution sector. As employment
increases purchasing power of people also increases which raises their standard of living.
 8. Increase In Investment :-International trade gives a boost to investment. The increase in
investment takes place as follows Inter-regional investment, Intra- regional investment,
local or domestic investment. The increase in investment further gives a boost to
international trade and economic development of participating countries.

9. Enhancement Of Consumer Welfare :-International trade leads to consumer welfare.

Consumers enjoy the benefits of quality goods and that too at reduced prices. Again due
to international trade employment increases which increases the purchasing power of
people and thus, there is enhancement of consumer welfare.

10. Non-economic advantages like political, social and cultural advantages to be gained by
fostering international trades like in the case of the ASEAN, AFTA, EEC,etc

BASIS OF INTERNATIONAL TRADE

The basis of trade tries to answer the question of why trade across national border takes place.
The difference in opportunity cost of production of commodities is the basis for international
trade. In this respect it differs not at all from domestic trade. International trade arises because a
country specializes in the production of certain goods and services and thus produces more than
enough to supply the domestic demand. Obviously it must export the surplus to continue the
specialization. To receive a return for its exports, a country must ultimately import either goods
or services. Imports pay for exports -both of which may consist of services as well as of goods.
There are various theories arising from the concept of differences in the opportunity cost of
production forming the basis of international trade.

1. Opportunity cost theory (Gottfried Haberler, 1933)

The opportunity cost of a product is the amount of another product that must be given up
in order to releases just enough resources to produce one additional unit of the first
product. According to this theory, a nation with a lower opportunity cost for a commodity
has a comparative advantage in that commodity and comparative disadvantage in another
commodity.

1. Absolute cost theory

A country is said to have an absolute cost advantage if the cost of producing a commodity
in the country is lesser than the cost of producing the same commodity in another country
According to Adam Smith, the father of economics, the basis for International trade is
absolute cost advantage. He focused on the supply side of trade. Trade between two
countries would be mutually beneficial if the cost of producing a commodity in one country
is lesser than the cost of producing the same commodity in another country. i.e., absolute
cost advantage. In other words, trade would results in a profit as long as prices between
two places differ by more than the transportation costs between those two places.

ABSOLUTE COST DIFFERENCE

Commodities country A country B Comparative cost

(cost in labour hours) ratios
X 10 20 10/20 =0.5
Y 20 10 20/10 =2
Domestic exchange 1x = (1/2)y 1x = 2y
rate

Country A has an absolute advantage over B in the production of X. Country B has an

absolute advantage over A in the production of Y. So A will specialise in X and export its
surplus to B. B will specialise in Y and export its surplus to A. Thus when there is absolute
cost advantage trade takes place between countries.

Criticism

            Though Smith's theory is clearly expressed, it is not convincing. The theory could
not explain why and how trade takes place even if one of the countries has disadvantages in
the production of all goods

Equal Cost Difference :-

            According to Ricardo, Trade and Specialisation is not advantageous if there is an

equal cost difference.

Commodities country A country B Comparative cost

(cost in labour hours) ratios
X 10 15 10/15 =0.66
Y 20 30 20/30 =0.66
Domestic exchange 1x = (1/2)y 1x = 2y
rate

Due to equal cost ratio, the comparative cost ratio is same in both countries. So
specialisation and trade do not take place between these two countries.

2. Comparative cost theory (David Ricardo)

Smith model of trade was extended by Ricardo, who showed that even if a single country
showed an absolute advantage in the production of all traded goods, trade can still be
profitable. He based this conclusion on the principle of comparative advantage. According
to this theory differences in comparative cost of production of commodities between
nations result in trade. A country should specialize in the production of those goods in
which it is more efficient and leave the production of other commodity to other country.
Then two countries will produce more and trade with each other.

The theory assumes;

1. There are two countries to enage in international trade-We will use Rainlands and
United Parkland

2. There are two products produced- i.e. Coffee and Computers

3. One factor of production exists- i.e. Labour

4. Factor productivity is constant

5. Perfect competition exists in the market

6. Homogeneous of factors-They have fixed and same abilities and productivity levels

7. Factors are perfectly mobile within country and between sectors –Can be shifted
from production of one product to another and from one region to another

8. Factors are immobile between countries –Endowments in one country cannot move
to another country.

9. Fixed level of technology

10. Full employment

11. Transport costs are ignored.

The table below indicates the quantities of coffee and computers that would be produced
by Rainlands and Parklands when a unit of labor is allocated in the production process.
This table also indicates the situation pertaining in each country before the countries enage
in international trade.

Coffee Computers

Parklands 50,000 50

Rainlands 100,000 400

From the table Rainlands has an absolute advantage in the production of both coffee and
computers per unit of labour employed. Let us analyze opportunity costs so as to determine
their respective comparative advantages. We achieve this by looking at the cost (foregone
benefit) of not producing one product so as to produce the other. In the absence of
international trade the opportunity cost is calculated as the ratio of the produced product
to the foregone alternative.

In a situation of autarky (i.e.no trade), the (relative) price of a good equals the opportunity
cost of producing that good in a country. Under free trade however, world (relative) prices
are determined by world supply and demand across countries (i.e. they fall between the
opportunity costs of the two countries)

If Parklands specializes in coffee, it will have to forego 50/50,000 = 0.001 units of computers
for each unit of coffee produced. If however Parklands decides to specialize in computers, it
would forego 50,000/50 = 1,000 units of coffee for every unit of computers produced.
Likewise, if Rainlands specializes in coffee, it will have to forego 400/100,000 = 0.004 units
of computers for each unit of coffee produced. If however Rainlands decides to specialize in
computers, it would forego 100,000/400 = 250 units of coffee for every unit of computers
produced. The table below summarizes the opportunity costs for both Rainlands and
Parklands if they specialized in production of one of the products

Summary the opportunity costs for specializing

Opportunity cost of Coffee Opportunity cost of Computers

Parklands 1,000 0.001

Rainlands 250 0.004

From the table we can conclude that Parkland has a comparative advantage in the
production of coffee and Rainlands has a comparative advantage in production of
computers. For this reason, Rainlands should specialize in production of computers and
Parklands in coffee and the two countries should engage in international trade and exchage
the commodities in which they have a comparative advantage with those in which they are
disadvantaged.

If the opportunity cost (relative price) of coffee is higher in Rainlands than in Parklands, it
is profitable for the two countries if Parklands exports coffee to Rainlands and imports
computers from there.

Effect of trade under comparative advantage.

Now let us examine the effect of transferring one unit of labor to specialize in production of
a product where each country has a comparative advantage. As one unit of labour is
specialized in production of coffee, Parklands foregoes (loses) 50 units of units of computers
to gain 50,000 units of coffee. Likewise, as one unit of labor is transferred from the
production of coffee to the production of computers, Rainlands loses 100,000 units for a
gain of 400 units. As the countries specialize in their respective comparative advantages,
the changes in their outputs will look as follows;

Changes in outputs due to specialisation

Coffee Computers

Parklands +50,000 -50

Rainlands -100,000 +400

But each country will still need the products it has not produced. Rainlands will demand
for the 100,000 units of coffee from Parklands. Parkland to be able to produce that amount
will have to allocate 2 units of labor. The effect of this labor transfer is that Parklands will
forego production of 100 units of computers so as to meet the demand for coffee by
Rainlands. Rainlands still using its one unit of labor will have to exchange its 50 units of
computers with the 100,000 units of coffee from Parklands. The table shows the
international trade related changes in output as countries utilize their respective labor
resource in the best alternative;

Changes in production with specialisation so as to engage in international trade

Coffee Computers

Parklands +100,000 -100

Rainlands -100,000 +350

Total change in output 0 250

Due to specialization and trading based on comparative advantage, additional 250 units of
computers are produced and consumed without reducing the quantities of coffee produced
and traded in the international market.

In general, countries gain from free trade because the output and consumption possibilities
of both countries expand as opposed to no trade. Let us try to analyze the mechanism
allowing countries to gain from trade. If the world price of coffee is equal to $1and the
price of a computer equals $500, Parklands can buy 200 units of computers from the
Rainlands by exporting 100,000 coffee units. As both countries engage in international
trade, they end up consuming more computers and the same amount of coffee than in the
situation without trade.

Coffee (price=$1) Computers (price=$500)

Parklands 50,000 50

Rainlands 100,000 400

Total change in output 0 250

Therefore enabling countries to specialize their resources in the economic activities in

which they have a comparative advantage and then engage in international trade to get
products in which they have a comparative disadvantage does not only expand the size of
global production, it allows for expanded “ global consumption possibilities”.

EVALUATION OF THE THEORY OF COMPARATIVE COST

Criticisms

However, the principle of comparative advantage can be criticised in a several ways:

1. It may overstate the benefits of specialisation by ignoring a number of costs. These

costs include transport costs and any external costs associated with trade, such as
air and sea pollution.

2. The theory also assumes that markets are perfectly competitive - in particular, there
is perfect mobility of factors without any diminishing returns and with no transport
costs. The reality is likely to be very different, with output from factor inputs
subject to diminishing returns, and with transport costs. This will make the PPF for
each country non-linear and bowed outwards.  If this is the case, complete specialisation
might not generate the level of benefits that would be derived from linear PPFs. In other
 words, there is an increasing opportunity cost associated with increasing specialisation.
For example, it may be that the maximum output of cars produced by country A is only
20 million (compared with 30), and the maximum output of trucks produced by country
B might only be 16 million instead of 21 million. Hence, the combined output from trade
might only be 46 million units (instead of the 51 million units initially predicted).

4. Complete specialisation might create structural unemployment as some workers

cannot transfer from one sector to another.

5. Relative prices and exchange rates are not taken into account in the simple theory of
comparative advantage. For example if the price of X rises relative to Y, the benefit
of increasing output of X increases.

6. Comparative advantage is not a static concept - it may change over time. For
example, nonrenewable resources can slowly run out, increasing the costs of
production, and reducing the gains from trade. Countries can develop new
advantages, such as Vietnam and coffee production. Despite having a long history of
coffee production it is only in the last 30 years that it has become a global player.
seeing its global market share increase from just 1% in 1985 to 20% in 2014,
making it the world's second largest producer.

7. Many countries strive for food security, meaning that even if they should specialise
in non-food products, they still prefer to keep a minimum level of food production.
 8. The principle of comparative advantage is derived from a highly simplistic two
good/two country model. The real world is far more complex, with countries
exporting and importing many different goods and services.

9. According to influential US economist Paul Krugman, the continual application of

economies of scale by global producers using new technology means that many
countries, including China, can produce very cheaply, and export surpluses. This,
along with an insatiable demand for choice and variety, means that countries
typically produce a variety of products for the global market, rather than specialise
in a narrow range of products, rendering the traditional theory of comparative
advantage almost obsolete.

However, the underlying principle of comparative advantage can still be said to give
some ‘shape’ to the pattern of world trade, even if it is becoming less relevant in a
globalised world. 

COMPARATIVE ADVANTAGE

Among the main sources of comparative advantage are the following:

1 Climate and natural resources.

2 Relative abundance of labor and capital.Some countries have a comparative advantage in

producing goods requiring highly skilled workers. Others have a comparative advantage
requiring unskilled workers and relatively simple machinery.

3 Technology.

Some countries are strong in product technologies, which involve the ability to develop new
products. Other countries are strong in process technologies, which involve the ability to
improve the processes used to make existing products.

4 External economies.

Once an industry becomes established in an area, firms that locate in that area gain advantages
over firms located elsewhere.