Gains From Trade

Surely at some point in your life, you have made a trade with someone, even if it is something small like trading one piece of candy for another you like better. You made the trade because it made you happier and better off. Countries trade on a similar principle, only more advanced. Countries engage in trade to, ideally, make their citizens and economies better off in the end. These benefits are known as the gains from trade. To learn more about how exactly countries benefit from trade, you will have to keep reading on!

Gains From Trade Gains From Trade

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Table of contents

    Gains from Trade Definition

    The most straightforward gains from trade definition is that they are the net economic benefits that a person or nation gains from engaging in trade with another. If a nation is self-sufficient, then it has to produce everything it needs itself, which can be difficult because it either needs to allocate resources to every good or service it wants, or it has to prioritize and limit good diversity. Trading with others allows us to have access to a more diverse array of goods and services and to specialize in the production of goods that we excel at.

    Trade occurs when people or countries exchange goods and services with each other, usually to make both parties better off.

    Gains from trade are the benefits an individual or country experiences when they engage in trade with others.

    • The two main types of gains from trade are dynamic gains and static gains.

    Static gains from trade are those that increase the social welfare of the people living in the nations. When a nation can consume beyond its production possibilities frontier after engaging in trade, it has made static gains from trade.

    Dynamic gains from trade are those that help the nation's economy grow and develop faster than if it had not engaged in trade. Trade increases a nation's income and production capability through specialization, which allows it to save and invest more than it could pre-trade, making the nation better off.

    A country's production possibilities frontier (PPF) is sometimes called the production possibilities curve (PPC).

    It is a curve that shows the different combinations of two goods that a country or firm can produce, given a fixed set of resources.

    To learn about the PPF, check out our explanation - Production Possibility Frontier!

    Gains from Trade Measures

    Gains from trade measure how much countries gain when they engage in international trade. To measure this, we need to understand that not every country will be good at producing every good. Some countries will have advantages over others due to their climate, geography, natural resources, or established infrastructure.

    When one country is better at producing a good than another, they have a comparative advantage in producing that good. We measure a country's production efficiency by taking a look at the opportunity cost they incur by producing the good. The country that has a lower opportunity cost is more efficient or better at producing the good than the other. A country has an absolute advantage if it can produce more of a good than another country using the same level of resources.

    A country has a comparative advantage when it can produce a good with a lower opportunity cost than another.

    A country has an absolute advantage when it is more efficient at producing a good than another country.

    The opportunity cost is the cost of the next best alternative that is given up to obtain the good.

    When two nations decide to engage in trade, they will establish who has the comparative advantage when producing each good. This establishes which nation has a lower opportunity cost when producing each good. If a nation has a lower opportunity cost for producing Good A, while the other is more efficient at producing Good B, they should specialize in producing what they are good at and trade their excess with each other. This makes both nations better off in the end because they both maximize their production and still benefit from having all the gods that they want. The gains from trade are this increased benefit that both nations experience because they engage in trade.

    Gains from Trade Formula

    The gains from trade formula is calculating the opportunity cost for each nation to produce a good, seeing which nation had the comparative advantage for producing which goods. Next, a trading price is established that both nations accept. In the end, both nations should be able to consume beyond their production capabilities. The best way to understand is to work through the calculations. Below in Table 1, we see the production capabilities for Country A and Country B for shoes versus hats per day.

    HatsShoes
    Country A5025
    Country B3045
    Table 1 - Production capabilities for hats versus shoes for countries A and B.

    To calculate the opportunity cost each nation faces when producing each good, we need to figure out how many hats it costs each nation to produce one pair of shoes and vice versa.

    To calculate the opportunity cost of producing hats for Country A, we divide the number of shoes by the number of hats produced:

    \(Opportunity\ Cost_{hats}=\frac{25}{50}=0.5\)

    And for the opportunity cost of producing shoes:

    \(Opportunity\ Cost_{shoes}=\frac{50}{25}=2\)

    HatsShoes
    Country A0.52
    Country B1.50.67
    Table 2 - Opportunity costs of producing hats and shoes in each country.

    We can see in Table 2 that Country A has a lower opportunity cost when producing hats, and Country B does when producing shoes.

    This means that for every hat produced, Country A only gives up 0.5 pairs of shoes, and for every pair of shoes, Country B only gives up 0.67 hats.

    It also means that Country A has a comparative advantage when producing hats, and Country B does when producing shoes.

    Calculating Opportunity Cost

    Calculating the opportunity cost can get a bit confusing. To calculate it, we need the cost of the good we chose and the cost of the next best alternative good (which is the good we would have chosen had we not gone with the first choice). The formula is:

    \[\hbox {Opportunity Cost}=\frac{\hbox{Cost of Alternative Good}}{\hbox{Cost of Chosen Good}}\]

    For example, if Country A can either produce 50 hats or 25 pairs of shoes, the opportunity cost for producing one hat is:

    \(\frac{25\ \hbox {pairs of shoes}}{50\ \hbox {hats}}=0.5\ \hbox{pairs of shoes per hat}\)

    Now, what is the opportunity cost of producing one pair of shoes?

    \(\frac{50\ \hbox {hats}}{25\ \hbox {pairs of shoes}}=2\ \hbox{hats per pair of shoes}\)

    If the two countries do not trade, Country A will produce and consume 40 hats and 5 pairs of shoes, while Country B will produce and consume 10 hats and 30 pairs of shoes.

    Let's see what happens if they do trade.

    Hats (Country A)Shoes (Country A)Hats (Country B)Shoes (Country B)
    Production and consumption without trade4051030
    Production500242
    TradeGive 9Get 9Get 9Give 9
    Consumption4191133
    Gains from trade+1+4+1+3
    Table 3 - Calculating gains from trade

    Table 3 shows us that if the countries decide to trade with each other, they will both be better off because they will both be able to consume more goods than they could before they traded. First, they have to agree on terms of trade, which in this case will be the price of the goods.

    To be profitable, Country A must sell hats at a price higher than its opportunity cost of 0.5 pairs of shoes, but Country B will only buy them if the price is lower than its opportunity cost of 1.5 pairs of shoes. To meet in the middle, let's say that the price of one hat equals one pair of shoes. For every hat, Country A will get one pair of shoes from Country B and vice versa.

    In Table 3, we can see that Country A traded nine hats for nine pairs of shoes. This made it better off because now it can consume one hat and four extra pairs of shoes! This means that Country B also traded nine for nine. It can now consume one extra hat and three extra pairs of shoes. The gains from trade are calculated as the difference in quantity consumed before engaging in trade and after trading.

    Country B has a comparative advantage over County A when producing shoes since it only costs them 0.67 hats to produce one pair of shoes. To learn more about comparative advantage and opportunity cost, check out our explanations:

    - Opportunity Cost

    - Comparative Advantage

    Gains from Trade Graph

    Looking at the gains from trade on a graph can help us visualize the changes that occur along both countries' production possibilities frontier (PPF). Both nations have their respective PPFs that show how much of each good they can produce and at what ratio. The goal of trading is to have both nations be able to consume outside of their PPFs.

    Gains From Trade graph showing two countries gains from trade StudySmarterFig. 1 - Both Country A and Country B receive gains from trade

    Figure 1 shows us that the gains from trade for Country A were one hat and four pairs of shoes, while Country B gained one hat and three pairs of shoes once it started trading with Country A.

    Let's start with Country A. Before it started trading with Country B, it was producing and consuming at point A on the PPF marked Country A, where it was only producing and consuming 40 hats and 5 pairs of shoes. After it began trading with Country B, it specialized by only producing hats at point AP. It then traded 9 hats for 9 pairs of shoes, allowing Country A to consume at Point A1, which is beyond its PPF. The difference between point A and point A1 is Country A's gains from trade.

    From County B's perspective, it was producing and consuming at point B before engaging in trade with Country A. It was only consuming and producing 10 hats and 30 pairs of shoes. Once it began trading, Country B started producing at point BP and was able to consume at point B1.

    Gains from Trade Example

    Let's work through a gains from trade example from start to finish. To simplify, the economy will consist of John and Sarah, who both produce wheat and beans. In one day, John can produce 100 pounds of beans and 25 bushels of wheat, while Sarah can produce 50 pounds of beans and 75 bushels of wheat.

    BeansWheat
    Sarah5075
    John10025
    Table 4 - John and Sarah's production capabilities of beans and wheat.

    We will use the values from Table 4 to calculate each person's opportunity cost of producing the other good.

    BeansWheat
    Sarah1.50.67
    John0.254
    Table 5 - The opportunity cost of producing wheat versus beans

    From Table 5, we can see that Sarah has a comparative advantage when producing wheat, while John is better at producing beans. When Sarah and John are not trading, Sarah consumes and produces 51 bushels of wheat and 16 pounds of beans, and John consumes and produces 15 bushels of wheat and 40 pounds of beans. What would happen if they started trading?

    Beans (Sarah)Wheat (Sarah)Beans (John)Wheat (John)
    Production and consumption without trade16514015
    Production 666805
    TradeGet 39Give 14Give 39Get 14
    Consumption45524119
    Gains from trade+29+1+1+4
    Table 6 - Calculating gains from trade

    Table 6 shows that engaging in trade with each other is beneficial to both Sarah and John. When Sarah trades with John, she gains an extra bushel of wheat and 29 pounds of beans. As for John, he gains an extra pound of beans and an extra 4 bushels of wheat.

    Gains From Trade graph showing two peoples gains from trade StudySmarterFig. 2 - Sarah and John's gains from trade

    Figure 2 shows how Sarah and John benefited from trading with each other. Before the trade, Sarah was consuming and producing at point A. Once she started trading, she could focus on producing at point AP and be able to consume at point A1. This is significantly outside of her PPF. As for John, before, he could only produce and consume at point B. Once he started trading with Sarah, he could produce at point BP and consume at point B1, which is also significantly above his PPF.

    Gains From Trade - Key takeaways

    • Gains from trade are the net benefits a nation earns from trading with other nations.
    • The opportunity cost is the price of the next best alternative that has been forgone.
    • When countries trade, their main goal is to make themselves better off.
    • Trade benefits the consumer because it provides them access to a more diverse selection of goods, and it allows counties to specialize in producing more of what they are good at.
    • A country has a comparative advantage when it can produce a good with a lower opportunity cost than another.
    Frequently Asked Questions about Gains From Trade

    What is an example of gain from trade?

    An example of gains from trade is when both countries can consume more of both apples and bananas after they begin trading.

    What does gains from trade refer to?

    Gains from trade are the benefits an individual or country experiences when they engage in trade with others.

    What are the types of gains from trade?

    The two types of gains from trade are dynamic gains and static gains where static gains are those that increase the social welfare of the people living in the nations and dynamic gains are those that help the nation's economy grow and develop faster.

    How does comparative advantage lead to gains from trade?

    Comparative advantage helps establish the opportunity costs nations face when producing goods and thus they will trade with other nations for goods that have a high opportunity cost for them while specializing in the goods where they have a low opportunity cost. This reduced the opportunity cost for both nations and increases the number of goods available in both, resulting in gains from trade. 

    How do you calculate gains from trade?

    The gains from trade are calculated as the difference in quantity consumed before engaging in trade and after trading.  

    Test your knowledge with multiple choice flashcards

    What are the types of gains from trade?

    ____ gains from trade are those that increase the ____ of the people living in the nations.

    ____ gains from trade are those that help ____ grow and develop faster than if it had not engaged in trade.

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