Gains From Trade

Gains from Trade

Consider the trading positions of the United States and Saudi Arabia after they have specialized and traded. Before trade, Saudi Arabia produces/consumes 60 barrels of oil and 10 bushels of corn. The United States produces/consumes 20 barrels of oil and 60 bushels of corn. Given their current production levels, if the United States can trade an amount of corn fewer than 60 bushels and receives in exchange an amount of oil greater than 20 barrels, it will gain from trade.

With trade, the United States can consume more of both goods than it did without specialization and trade. (Recall that the tutorial Introduction to Economics defined specialization as it applies to workers and firms. Specialization is also used to describe the occurrence when a country shifts resources to focus on producing a good that offers comparative advantage.) Similarly, if Saudi Arabia can trade an amount of oil less than 60 barrels and receive in exchange an amount of corn greater than 10 bushels, it will have more of both goods than it did before specialization and trade. This table illustrates the range of trades that would benefit both sides.

The underlying reason why trade benefits both sides is rooted in the concept of opportunity cost, as the following Clear It Up feature explains. If Saudi Arabia wishes to expand domestic production of corn in a world without international trade, then based on its opportunity costs it must give up four barrels of oil for every one additional bushel of corn. If Saudi Arabia could find a way to give up less than four barrels of oil for an additional bushel of corn (or equivalently, to receive more than one bushel of corn for four barrels of oil), it would be better off.

Recall that David Ricardo argued that if each country specializes in its comparative advantage, it will benefit from trade, and total global output will increase. How can we show gains from trade as a result of comparative advantage and specialization? This table shows the output assuming that each country specializes in its comparative advantage and produces no other good. This is 100% specialization. Specialization leads to an increase in total world production. (Compare the total world production in this table to that in this table.)

What if we did not have complete specialization, as in this table? Would there still be gains from trade? Consider another example, such as when the United States and Saudi Arabia start at C and C', respectively, as shown in This figure. Consider what occurs when trade is allowed and the United States exports 20 bushels of corn to Saudi Arabia in exchange for 20 barrels of oil.

Production Possibilities Frontier in Saudi Arabia

Gains from trade of oil can increase only by achieving less from trade of corn. The opposite is true as well: The more gains from trade of corn, the fewer gains from trade of oil.

Starting at point C, which shows Saudi oil production of 60, reduce Saudi Oil domestic oil consumption by 20, since 20 is exported to United States and exchanged for 20 units of corn. This enables Saudi to reach point D, where consumption of oil is now 40 barrels and consumption of corn has increased to 30 (see this figure). Notice that even without 100% specialization, if the “trading price,” in this case 20 barrels of oil for 20 bushels of corn, is greater than the country’s opportunity cost, the Saudis will gain from trade. Since the post-trade consumption point D is beyond its production possibility frontier, hence Saudi Arabia has gained from trade.