Gains from Trade: Static and Dynamic Gains

Here we detail about the two types of gains from trade.

The two types of gains are: (1) Static Gains, and (2) Dynamic Gains.

Type 1# Static Gains from Trade:

The static gains from trade are measured by the increase in the utility or level of welfare when there is opening of trade between the countries. Note that in modern economics increase in utility or welfare is measured through indifference curves. When as a result of foreign trade, a country moves from a lower indifference curve to a higher one, it implies that the welfare of the people has increased.

To show the static gains from trade, let us take an example. Suppose two commodities cloth and wheat are produced in two countries, India and U.S.A., before they enter into trade. Their production possibility and indifference curves are shown in Figures 23.8 and 23.9. It will be seen from Fig. 23.8 that before trade India would be in equilibrium at point F (i.e. produc­ing and consuming at point F ) where the price line pp’ is tangent to both production possibility curve AB and indifference curve IC₁.

The slope of the price line pp’ shows the price-ratio (or cost ratio) of the two commodities in India. India can gain if international price-ratio (terms of trade) is different from the domestic price-ratio represented by pp’. Suppose the terms of trade settled are such that we get tt as the terms of trade line showing the price ratio at which goods can be ex­changed between India and the U.S.A. Now, with tt’ as the given terms of trade line (i.e. new price- ratio line).

India would produce at point R at which the terms of trade line tt is tangent to her production possibility curve. It will be seen from Fig. 23.8 that at point R, India will produce more of cloth in which it has comparative advantage and less of wheat than at F. Though India will produce at point R on his production possibility curve, where the terms of trade line tt is tangent to her production possibility curve AB it will not consume the quantities of wheat and cloth repre­sented by the point R.

Given the new price-ratio represented by the terms of trade line tt the con­sumption of the goods will depend upon the pattern of demand of the country. To incorporate this factor we have drawn social indifference curves IC₁ IC₂ of the country. These social indifference curves represent the demands for the two goods, or, in other words, the scale of preferences be­tween the two goods of the society.

It will be seen from Fig. 23.8 that the terms of trade line tt is tangent to the social indifference curve IC₂ of India at point S. Therefore, after trade India will consume the quantities of cloth and wheat as represented by point S. It is therefore clear that as a result of specialisation and trade India has been able to shift from point F on indifference curve IC₁ to the point S on higher indifference curve IC₂.

This is the gain obtained from specialisation and trade and implies that trade enables a country to increase her consumption beyond her production possibility curve. (It will be seen that point S lies beyond the production possibility curve AB of India).

It is also worth noting that when specialisation and trade occur, the quantities of the two goods consumed by a country will differ from the quantities of the two goods produced by her. In Fig. 23.8 whereas India produces the quantities of two goods represented by point R, it will consume the quantities of the two goods represented by the point 5. The difference arises due to exports and imports of goods. In Fig. 23.8, while India will export MR quantity of cloth it will import MS quantity of wheat.

Now consider the position of U.S.A. which is depicted in Fig. 23.9. Given its factor endow­ments CD is the production possibility curve between wheat and cloth of the U.S.A. It is evident from the production possibility curve CD that the factor endowments of the USA are more favourable for the production of wheat.

It will also be seen from Fig. 23.9 that before trade the U.S.A. will produce and consume at point E on her production possibility curve CD where the domestic price ratio line pp and indifference curve IC₁ are tangent to it. The USA will gain from trade if it can sell at a different price ratio from pp. Suppose the terms of trade line is tt.

With this terms of trade line tt the U.S.A. will produce at point G on her production possibility curve CD. She will now produce more of wheat in which she has comparative advantage and less of cloth than before. On the other hand, given the price ratio as represented by the terms of trade line tt the USA will consume the quantities of the two goods given by the point H where the terms of trade line tangent to her indifference curve lC2 is.

It is therefore clear that the specialisation and consequently trade with India has enabled the U.S.A. to shift from her lower indifference curve IC₁ to her higher indifference curve IC₂. This is the gain which she obtains from trade. By comparing the production and consumption points of the U.S.A. it will be observed that the U.S.A. will export NG amount of wheat and import NH amount of cloth.

It is worth remembering that while in case of constant opportunity cost, each country attains complete specialisation, that is, it produces one of the two goods after trade, in case of increasing opportunity cost specialisation is not complete. In case of increasing opportunity cost, a country produces only a relatively large amount of the good in which it has comparative advantage.

Type 2# Dynamic Gains from Trade: International Trade and Economic Growth:

Specialisation followed by international trade makes it possible for the countries to have more of both commodities than before.

This additional production of commodities is the gain which flows from specialisation by different countries in the production of different goods and then trading with each other. Specialisation by different countries in the production of different goods according to their efficiency and re­source endowment brings about an increase in the total world production by increasing the level of their productivity.

It is this trade that makes possible the division and specialisation of labour on which higher productivity of different countries is so largely based. If the various countries could not exchange the products of their specialized labour, each of them would have to be self-sufficient (i.e., each of them would have to produce all goods it requires, even those which it could not produce efficiently) with the result that their productivity and standard of living will go down.

Thus, according to Professor Haberler, “International division of labour and international trade, which enable every country to specialise and to export those things which it can produce cheaper in exchange for what others can provide at a lower cost, have been and still are one of the basic factors promoting economic well being and increasing national income of every participating coun­try.”

We thus see that the main gain from specialisation and trade is the increase in national produc­tion, income and consumption of the participating countries. But the above explanation of gains from trade in terms of comparative cost theory deals only with static gains from trade, that is, the gains which accrue to a country from reallocation of a given amount of resources.

We shall now discuss dynamic gains from trade that is gains from trade which accrue to a country in terms of promotion of its economic growth.

Dennis Robertson described foreign trade as “an engine of growth” With greater income and production made possible by specialisation and trade, greater savings and investment become pos­sible and as a result higher rate of economic growth can be achieved.

Through promotion of ex­ports, a developing country can earn valuable foreign exchange which it can use for the imports of capital equipment and raw materials which are so essential for economic development. Therefore, Professor Haberler argues that since international trade raises the level of income, it also promotes economic development.

He thus remarks:

“What is good for the national income and the standard living is, at least potentially, also good for economic development; for the greater the volume of output the greater can be the rate of growth—provided the people individually or collectively have the urge to save and to invest and economically to develop”.

The higher the level of output, the easier it is to escape the “vicious circle of poverty” and to “take off into self-sustained growth” to use the jargon of modern development theory. Hence, if trade raises the level of income, it also promotes economic development.

As pointed out above, the importance of and gain from international trade follows from the theory of comparative cost. Specialisation by different countries according to their production effi­ciency and factor endowments ensures optimum use and allocation of resources of the countries.

Differences in production possibilities and costs of production of various products between differ­ent countries of the world are so great that tremendous gain in terms of additional output and income accrues to the world community from international specialisation and trade.

For instance, the rela­tive differences in cost of production of industrial products and food and raw materials between developed and developing countries are almost infinite in the sense that either type of these coun­tries cannot produce what they buy from the other.

But the theory of comparative cost is static, it indicates only those gains which accrue to the trading countries as a result of the differences in given cost of production and given production possibilities of various products at a given point of time.

As pointed out above, besides the static gains indicated by comparative cost theory, international trade bestows very important indirect gains and benefits, which are generally described as dynamic gains, upon the participating coun­tries. These dynamic gains also promote economic growth in the participating countries.

It is worth noting that both developed and developing countries have obtained benefits from trade. The inter­national trade has contributed a good deal to the economic development of under-developed coun­tries.

To quote Professor Haberler again “If we were to estimate the contribution of international trade to economic development especially of the under-developed countries solely by the static gains from trade in any given year on the usual assumption of given production capabilities, we would indeed grossly under-rate the importance of trade. For over and above the direct static gains dwelt upon by the traditional theory of comparative cost, trade bestows very important indirect benefits upon the participating countries”.

Dynamic gains which’ accrue to the developing countries from international trade are as follows:

Firstly, through foreign trade, developing countries get material means of production such as capital equipment, machinery and raw materials which are so essential for economic growth of these countries. There has been rapid technological progress in the developed countries. This ad­vanced and superior technology is incorporated or embodied in various types of capital goods.

It is thus clear that developing countries derive tremendous gains from technological progress in the developed countries through the imports of capital goods such as machinery, transport equipment, vehicles, power generation equipment, road building machinery, medicines, chemicals.

It is worth mentioning here that the pattern of import trade of the underdeveloped countries has changed in the last several years and now consists of greater quantity of various forms of capital goods and less of textiles.

Secondly, even more important than the importation of capital goods is the transmission of technical know-how, skills, managerial talents., entrepreneurship through foreign trade. When the developing countries come to have trade relationship with the developed countries, they also often import technical know-how, with all their skills, managers, etc., from them.

With this they are also able to develop their own technical know-how, managerial and entrepreneurial ability. The growth of technical know-how, skill and managerial ability is an important requisite for economic develop­ment of developing countries.

Professor Haberler rightly says:

“The late-comers and successors in the process of development and industrialization have always had the great advantage that they could learn from the experiences, from the successes as well as from the failures and mistakes of the pioneers and forerunners… Today the developing countries ‘have a tremendous, constantly growing store of technical know-how to draw from. True, simple adoption of methods, developed for the conditions of the developed countries is often not possible. B₁ adaptation is surely much easier than the first creation…. Trade is the most important vehicle for the transmission of technological know- how…. Today there are a dozen industrial centres in Europe, the U.S., Canada, and Japan, and Russia which are ready to sell machinery as well as engineering advice and know-how.”