Topic #6: The Gains from Trade Dr David Penn Associate Professor of Economics and Director of the Business and Economic Research Center

Gains from Trade  Importance of specialization  Comparative advantage  Economic growth by trade  Absolute advantage

Gains from Trade in Economic History  Adam Smith (1776)  Trade allows us to specialize  Specialization makes us more productive  David Ricardo (1816)  Countries should trade based on their comparative advantage  Even when one country is more productive than the other, trade can benefit both.

Gains from Trade Model  Model:  Two countries: U.S. and Brazil  Two goods: large jets and small jets  Simplifying assumption: the production possibilities frontier is linear (constant opportunity costs)

Gains from Trade Argument  Compare consumption of large jets and small jets in two scenarios:  1) No trade between the U.S. and Brazil  2) U.S. and Brazil engage in trade  Does total consumption increase when the two countries engage in trade?

Gains from Trade  U.S. production possibilities frontier with no trade: Large jets Small jets The U.S. consumes 18 large jets and 16 small jets with given resources The opportunity cost of one small jet for the U.S. is ¾ of a large jet.

Gains from Trade  Brazil’s PPF with no Trade: Small jets Brazil consumes 8 large jets and 6 small jets. Large jets The opportunity cost of one small jet for Brazil is 1/3 of a large jet.

Comparative Advantage and Opportunity Cost  Gains from trade arise from comparative advantage.  Comparative advantage depends on differences in opportunity costs, not production costs.  Countries with differing opportunity costs will gain from trade, even if one country is more productive than the other.

Opportunity Costs  What is the opportunity cost of producing 1 small jet?  Brazil: 1/3 of a large jet  U.S.: ¾ of a large jet  Conclusion: Brazil is the low cost producer of small jets since its opportunity cost is lower. Brazil has a comparative advantage in small jets.

Opportunity Costs  What is the opportunity cost for producing 1 large jet?  Brazil: 3 small jets  U.S.: 4/3 of a small jet  Conclusion: the U.S. is the low cost producer of large jets since its opportunity cost is smaller. The U.S. has a comparative advantage in large jets.

Gains from Trade  Both countries should specialize in production according to their comparative advantage.  Consequently, the U.S. should produce more large jets and Brazil should produce more small jets.  Then the two countries should trade to obtain the other type of jet.

Gains from Trade  After specialization:  U.S. production:  30 large jets and 0 small jets  Brazil production:  0 large jets and 30 small jets  Then both countries engage in trade.

Trade  With no trade, both countries must consume only what they produce.  With trade, both countries may specialize and trade for the other good.  With trade, both countries benefit from comparative advantage.

Gains from Trade Results With no trade, both countries can only consume what they produce.

Gains from Trade Results With trade, each country specializes according to its comparative advantage. Suppose each country produces only one type of jet according to comparative advantage and trades for the other type of jet.

Comparative advantage & opportunity costs (again) Suppose the U.S. can trade for 2 small jets in exchange for 1 large jet. The U.S. benefits. (why?) Suppose Brazil can trade 2 small jets for one large jet. Brazil benefits.

Gains from Trade Results When trading 2 small jets for one large jet both countries benefit. These are the terms of trade. Other mutually beneficial terms of trade are possible.

Gains from Trade Results The terms of trade are 2 small jets in exchange for one large jet. Both countries can consume more of both types of aircraft with trade compared with no trade.

Gains from Trade  U.S. production possibilities frontier with trade Large jets Small jets U.S. consumption with no trade U.S. consumption with trade

Gains from Trade  Brazil’s PPF with Trade: Small jets Brazilian consumption with no trade. Large jets Brazilian consumption with trade. 10

Summary Two important points: 1) The gains from trade model shows that with specialization and trade, countries can consume more than if they were self-sufficient. 2) Every country (and every person) has a comparative advantage in something (and therefore a comparative disadvantage in something else.)