Question

Assuming that this is what is produced in each country (5 cars and 15 HD TVs), nothing more and nothing less, explain how both countries can benefit through trade. Again, be very specific in terms of identifying the gains from trade and how each country is better as compared to not trading at all.

Answer 1

Nations usually indulge in international trade for 2 major reasons:

1. Each country is endowed with a different set of resources which lead to different production possibilities. Thus, each country can benefit if they agree to specialize in what they produce relatively better than others.
2. Trade helps countries to attain economies of scale in production, that is, a country can produce more efficiently and at a much larger scale if it specializes in a limited range of goods, as compared to a situation where the country tries to be self sufficient and produce everything on its own.

Any country has an absolute advantage in production if it can produce a good with lesser resources as compared to other countries. Absolute Advantage is an outcome of natural endowment of resources a country has. On the other hand, a country has a comparative advantage if it can produce a good at a lower cost in terms of other goods as compared to another country. Trade arises because of the concept of comparative advantage.

Two countries enter into trade with each other when they have comparative advantage in production of a good. Having comparative advantage over other countries means that the opportunity cost of producing a good in that country is lower than in any other country. So, two countries entering into trade will have comparative advantage in the goods that they are exporting. However, the models of international trade which are based on the concept of comparative advantage assume perfect competition and constant returns to scale in production, thus ignoring the possibility of economies of scale as well as monopoly profits. Another drawback of the classical models of international trade is that these are based on the premise of international differences in endowments, factors used in production, labor productivity, etc. Hence, they fail to explain why developed countries such as US, EU, Japan etc. indulge in trade with each other since they have similar resources and technologies. Trade between such developed countries can be explained using the concept of economies of scale.

Individual markets are constrained by the variety of goods being produced and the scale of production. Opening the economies to trade and forming an integrated world market slackens these constraints, which leads to gains from trade for both countries.

In the given question, it is assumed that each country has the same production possibilities, thus producing 5 cars and 15 HD TVs. If the economies are closed, then the market for these goods is limited to their domestic demand. However, if both countries start trading with each other, the countries can gain mutually even if they do not differ in resources or technology because trade leads to an increased market size. The consumers in both countries get access to more variety of goods and the producers in both countries benefit from lower average costs in production because of economies of scale.