Gains from trade Andrew Wait (School of Economics) 1

An introduction to the gains from trade

Is the new free-trade agreement between the United States of America and Australia a
good idea? What determines what we would sell to the US and what they would sell to
Australia? And, more fundamentally, why do individuals and countries trade anyway
(and we know that trade has been occurring for a very long time)? This paper provides a
brief introduction to trade: specifically, we focus on what determines the patterns of trade;
and what are the sources of the gains from trade. In short, trade allows gains from
exchange and from specialisation. Further, trading parties will specialise in producing the
good or service in which they have the lower opportunity cost of production; this allows
more to be produced, potentially making all of the trading parties better off.

Gains from exchange

Take a simple situation in which Baz owns a bicycle which he never rides Baz places a
value of $0 from owing the bike. Chloe, on the other hand, does not own a bike but she
would like to. She would be willing to pay $100 to buy a bike. The two parties can get
together perhaps at a garage sale and make a deal with each other.

For arguments sake, lets assume that Baz sets the price of the price for the bike at $40.
Chloe is willing to buy the bike at this price. She makes the purchase, pays $40 but gets
$100 worth of enjoyment out of the bike Chloe is better off than before. What about
Baz? Before the trade is made he had a bike that he value at $0; after trade he gives up he
bike but gets $40. He is also better off. Note, trade has made both parties better off
trade did not just benefit the seller or the buyer.

It is also worth making several other observations. The fact that Baz values the bike at $0
is not important. All that is important for there to be gains from exchange is that Chloe
(the buyer) values the bike more than Baz (the seller). And given that trade is voluntary,
Baz would not give up the bike for a lower price than what he values the good at. For
example, Baz might ride the bike occasionally, which he thinks is worth $30 to him. In
this case, Baz will need at least $30 to part with the bike. A price of $40 is still sufficient
for Baz to be willing to sell the bike, and given that Chloe is willing to buy it at that price
trade still takes place. Second, the price here ($40) is not the only price that allows
mutually beneficial trade to take place. Further, it is the price that splits the gains from
trade. We will discuss this issue at greater length later. Finally, the medium of exchange
in this example is money. This need not be the case. For example, with bartering two
parties directly exchange goods with each other; for example Baz swaps his bike for two
of Chloes CDs. We are not going to focus on the role of money here, but it can help
these coordinate (or facilitate) trades between parties. Presumably, Baz values the money
not for its own sake but because he can now buy something from another person. Using
money allows Baz and Chloe to trade, even if Chloe does not have anything that Baz
wants.

Gains from trade Andrew Wait (School of Economics) 2
Although this is a trivial example, gains from exchange apply in many situations. This is
true for both individuals and for countries. The key point is that both the buyer and the
seller can be made better off by engaging in exchange. this idea is also illustrated in the
following quote.

Tom Sawyer, Huckleberry Finn and the gains from exchange

Say whats that?
Nothing but a tick.
Whered you get him.?
Out in the woods.
Whatll you take for him?
I dont know. I dont want to sell him.
All right. Its a mighty small tick, anyway.
Oh, anybody can run a tick down that dont belong to them. Im satisfied with it. Its good enough for me.
Sho, theres ticks a-plenty. I could have a thousand of em if I wanted to.
Well, why dont you? Becuz you know mighty well you cant. This is a pretty early tick, I reckon. Its the
first one Ive seen this year.
Say, Huck Ill give you my tooth for him.
Les see it.
Tom got out a bit of paper and carefully unrolled it. Huckleberry viewed it wistfully. The temptation was
very strong. At last he said:
Is it genuwyne?
Tom lifted his lip and showed the vacancy.
Well, all right, said Huckleberry, its a trade.
Tom enclosed the tick in the percussion-cap box that had lately been the pinch bugs prison, and the boys
separated, each feeling wealthier than before.

M. Twain 1944, The Adventures of Tom Sawyer, Whitman, Racine, WI, pp. 54-55.


Gains from specialisation

The section above did not consider production. Now, we consider how parties can gain
by specialising in producing certain goods or service in which they have a comparative
advantage and then trading with each other.

To illustrate this point, consider the following example. There are two people, Bundy and
Fluff. Each can spend the 10 hours they have available to make either good x or good y,
or any combination of both of the goods. Bundy can make 2 units of x in an hour or a
total of 20 units of x in the 10 hours. Bundy, alternatively can make 3 units of good y in
an hour (or a maximum of 30 units in the 10 hours). Fluff, on the other hand can make 4
units of x or 8 units of y in an hour.

The production possibility frontier for each person is shown in Figure 1. Bundy can
produce a maximum of 20 units of x or a maximum of 30 units of y. Fluff can produce a
maximum of 40 units of x, shown on the x axis, or a maximum o 80 units of y. Note, that
the opportunity cost for each party is constant as a result the slope on each PPF is
constant.
Gains from trade Andrew Wait (School of Economics) 3

Figure 1.



















First, let us assume that there is no trade between the two parties. In this case, a party
consumes what they produce. For arguments sake, Bundy spends 5 hours producing x
and the rest of the time producing y. This means that Bundy produces and consumes 10
units of x and 15 units of y. Fluff, for her part, also spends 5 hours producing each of the
goods; this means that she produces and consumes 20 unit of x and 40 units of y.

Figure 2.


















Bundys ppf
Fluffs ppf
y
x
x
y
30
20
80
40
Bundys ppf, consump
y
x
30
20
15
15.5
10
Bundys cons
without trade
Bundys cons
with trade
11
Gains from trade Andrew Wait (School of Economics) 4
How can trade help? Consider the following proposed trade between the two: Bundy
spends all his time on producing x and trades 9 units of x for 15.5 units of y from Fluff.
For her part, Fluff spends 7 hours producing y and just 3 hours on x; of course, Fluff sells
15.5 units of y for 9 units of x from Bundy.

Figure 2 and 3 show the pre- and post-trade levels of consumption. In Figure 2 Bundy
pre-trade consumed 10 units of x and 15 units of y. With trade, Bundy produces 20 units
of x and no units of y. But after trade he gets to consume 11 units of x and 15.5 units of y.
So trade makes Bundy better off by 1 unit of x and 0.5 units of y.

What about Fluff? Fluff before trade produced and consumed 20 units of x and 40 units
of y. With trade, Fluff concentrates on producing more y. She produces just 12 units of x
but makes 56 units of y. She then trades with Bundy and consumes 21 units of x (12 that
she made plus 9 from Bundy) and consumes 40.5 units of y (she made 56 but had to give
Bundy 15.5 as part of the trade). But in the end Fluff consumes 1 more unit of x and 0.5
more units of y with trade than without trade.

Figure 3.



















Trade has allowed both Fluff and Bundy to consume more of both goods. Moreover, both
parties are able to consume outside of their production possibility frontiers. It has to be
the case that more of each good is being produced if this is to be true. So, what is driving
this increase in total production? Before answering this question, we need to define two
terms:

Absolute advantage: when a party is more productive at producing a good or service.

Comparative advantage: when a party has a lower opportunity cost of producing a good.
Fluffs ppf, consump
y
x
40.5
40
40
20
Fluffs cons
without trade
Fluffs cons
with trade
80
21
Gains from trade Andrew Wait (School of Economics) 5

In this example, Fluff has the absolute advantage at producing both x and y. Absolute
advantage looks simply how much you can produce with a given input (ie one hour).
Comparative advantage, on the other hand, looks at opportunity cost. When Bundy
spends one hour making good x he could have spent that time producing good y the
opportunity cost of 2 units of x for Bundy is then not producing 3 units of y. Similarly for
Fluff, the opportunity cost of producing 4 units of x (in an hour) is not producing 8 units
of y. Simplifying these numbers, the opportunity cost for Bundy to produce 1 unit of x is
forgoing 1.5 units of y. For Fluff, the opportunity cost of producing 1 unit of x is forgoing
2 units of y. As a result, Bundy has a comparative advantage in producing x as he has a
lower opportunity cost of producing x than Fluff.

What about good y? The opportunity cost of producing 1 unit of y for Bundy is 2/3 a unit
of x. The opportunity cost of 1 unit of y for Fluff is a unit of x. Fluff has the
comparative advantage in producing y. Note that these numbers are the inverse of the
opportunity cost of x (in terms of y). This means that it is not possible for one party to
have the comparative advantage in producing both goods.

In the proposed trade Bundy specialised in producing x the good in which he has a
comparative advantage and Fluff specialised in producing y her comparative
advantage. By doing so, the parties collectively reduce the opportunity cost of production.
By reducing cost, more output can be produced with the same inputs the size of the pie
has been increased. This increase in output can be shared between the trading parties,
making everyone better off. Furthermore, despite having an absolute advantage in
producing both goods, Fluff can still benefit from trading with a less productive party (in
this example Bundy). All that is needed is that the opportunity costs differ between the
two parties.

When each party trades in the example, they get a better price than if they bought the
good off themselves. Consider Bundy he can buy 1 unit of y off himself by spending an
extra 20 minutes producing y, but this comes at the cost of forgoing 2/3 a unit of x. When
Bundy trades with Fluff, on the other hand, he gives up 9 units of for 15 units of y the
price of 1 unit of y when trading with Fluff is 9/1.55 = 0.58 units of x. This lower price
for y means that Bundy is enticed to trade. Fluff, at the same time gets a lower price for x
trading with Bundy than if she bought x off herself; with no trade Fluff can get a unit of x
by forgoing 2 units of y, but with trade she can get an extra unit of x for 15.5/9 = 1.72
units of y. Provided the proposed trading price is between the opportunity costs of the
two trading parties, each will be willing to trade.

Finally, note that this is a very general idea. The example dealt with two individuals, but
it applies equally well to countries if two countries specialise in producing the good in
which they have a comparative advantage, trade can be mutually beneficial. Note also, a
country can gain from trading with a country that is less productive (in producing every
good). Further, goods x and y could represent any goods or services of interest.