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The Gains from trade

4 January, 2016 - 17:04

We now permit each economy to specialize in producing where it has a comparative advantage. So Canada specializes completely by producing 35F and the US produces 8V. Having done this the economies must now agree on the terms of trade. The terms of trade define the rate at which the two goods will trade post-specialization. Let us suppose that a bargaining process leads to agreement that one unit of V will trade for six units of F. Such a trading rate, one that lies between the opportunity costs of each economy, benefits both economies. By specializing in F, Canada can now obtain an additional unit of V by sacrificing six units of F, whereas pre-trade it had to sacrifice seven units of F for a unit of V. Technically, by specializing in F and trading at a rate of 1:6 Canada’s consumption possibilities have expanded and are given by the consumption possibility frontier (CPF) illustrated in Figure 15.2. The consumption possibility frontier defines what an economy can consume after production specialization and trade.

The US also experiences an improved set of consumption possibilities. By specializing in V and trading at a rate of 1:6 its CPF lies outside its PPF and this enables it to consume more than in the pre-specialization state, where its CPF was defined by its PPF.

\mid Terms of trade define the rate at which the goods trade internationally.

\mid Consumption possibility frontier defines what an economy can consume after production specialization and trade.

Evidently, the US and Canada CPFs are parallel since they trade with each other at the same rate: if Canada exports six units of F for every unit of V that it imports from the US, then the US must import the same six units of F for each unit of V it exports to Canada. To illustrate the gains numerically, let Canada import 3V from the US in return for exporting 18F. Note that this is a trading rate of 1:6. Hence, Canada consumes 3V and 17F (Canada produced 35F and exported 18F, leaving it with 17F). It follows that the US consumes 5V, having exported 3V of the 8V it produced, and obtained in return 18F in imports. The new consumption bundles are illustrated in the figure: (17F, 3V) for Canada and (18F, 5V) for the US. Comparing these combinations with the pre-trade scenario, we see that each economy consumes more of one good and not less of the other. Hence the well-being of each has increased as a result of their increased consumption.

Comparative advantage constitutes a remarkable result. It indicates that gains to trade are to be reaped by an efficient economy, by trading with an economy that may be less efficient in producing each good.