Benefits and costs of international trade

Where do the gains from trade come from?

Trade makes a country better off in total because it can sell what it makes relatively cheaply, buy what it makes relatively dearly, and enjoy larger markets, more choice and tougher competition. The gains from trade are these net benefits.

Gains from tradeoverall welfare rises

• Exchange and specialization Memorize export what is relatively cheap, import what is relatively dear
• Economies of scale Use it a bigger market lowers average cost
• Variety Use it more choice for households and firms
• Competition Use it less domestic monopoly power
• Efficient resource use Use it inputs move to the best use
• Dynamic gains Know the idea learning by doing, spillovers, better institutions

The first source is exchange and specialization . Each country gets a better price for its exports, or pays less for imports than it would cost to make them at home. Resources shift toward the export industry and away from the import-competing one, and the country can consume a bundle it could not make alone.

“Gains from trade” does not say that every household and firm is better off. It says the overall benefit exceeds the overall loss, so the winners could, in theory, compensate the losers and still be ahead.

How do you find a comparative advantage?

A country has a comparative advantage in the good whose opportunity cost is lower: what it gives up of the other good to make one more unit. It is different from absolute advantage , which just means more output per unit of input.

$$OC_X = \frac{\text{output of the other good, } Y}{\text{output of this good, } X}$$

What does specialization add?

Say each country has 10 worker-days. Before trade, A uses 8 days on bikes and 2 on drones (48 bikes, 6 drones) and B splits 5 and 5 (10 bikes, 10 drones). World output is 58 bikes and 16 drones.

If A makes only bikes (60) and B only drones (20), the world has 60 bikes and 20 drones: more of both. They can then trade at a price that suits both. Each country should be willing to trade drones for bikes at any price between its own costs, so a drone must trade for more than 1 bike (B’s cost) and less than 2 bikes (A’s cost).

$$OC_{\text{exporter}} < P_{\text{trade}} < OC_{\text{importer}}$$

Exam tip Divide the other good’s output by this good’s output. The smaller answer marks the country with the advantage in this good.

Which models explain trade?

Know the idea

The traditional models explain trade by differences between countries. The Ricardian model points to differences in technology. The Heckscher-Ohlin model points to differences in factor endowments, such as labor and capital: a country rich in capital exports capital-intensive goods.

Models of trade

• Comparative advantage models Memorize countries differ, so they trade different goods
  • Ricardian differences in technology
  • Heckscher-Ohlin differences in factor endowments (labor, capital)
• Newer models Use it countries can be similar and still trade
  • Economies of scale bigger market, lower average cost
  • Product variety two-way trade in one industry (intra-industry)
  • Competition import rivals curb domestic pricing power

What do the newer models add?

They explain why similar countries still trade, and why trade is large between them.

• Economies of scale . A bigger market lets firms in industries such as aircraft or shipbuilding spread fixed costs, so average cost falls as output rises.
• Variety and intra-industry trade . Many industries are monopolistically competitive: firms sell differentiated products. Each country specializes in a few varieties, exports them and imports others. Households get more choice, and firms sell into two markets.
• Competition. Foreign rivals reduce the pricing power of domestic firms and force them to become more efficient.

Go deeper Dynamic gains: learning, spillovers and institutions

Research suggests trade liberalization can raise real gross domestic product (GDP), although how strong the link is remains debated. Channels include a better allocation of resources, higher productivity, learning by doing (unit cost falls as experience builds, as in aircraft assembly), knowledge spillovers from foreign research, and policies and institutions that reward innovation. These gains build slowly, which is why they are harder to measure than the first-round gains.

Go deeper Why is intra-industry trade so large among similar rich countries?

Their incomes and tastes are similar, so each wants a wide range of varieties, and their firms make differentiated goods. Neither needs to be better at making the good. Scale and variety, not technology or endowments, drive the trade.

Who bears the costs?

Trade shifts resources between industries, and the shift hurts some people. Less efficient firms in import-competing industries may close. Their workers face unemployment and need retraining for jobs in expanding industries. These are the adjustment costs of trade.

In the long run most displaced workers find work in expanding industries, and resources are better used. But those with skills tied to the shrinking industry, especially older workers, may be permanently worse off. Critics also point to rising income inequality. That is why “gains from trade” is a statement about the total, not about each group.