What are the Factors Determine Size of Gain of International Trade?

Following are the important factors determining the size of gain and its proportion:

1. Nature of Terms of Trade:

Terms of trade, i.e., the rate at which one country’s goods exchange against those of another, tend to affect the size of gain from trade. Terms of trade may be favourable or unfavourable to a country.

A favourable term of trade implies a relatively larger share of gain to a country and an unfavourable term of trade would mean a relatively smaller share of gain accruing to the country. Between the two countries, if one has a favourable term of trade, the other must necessarily have an unfavourable term of trade. According to Ricardian example (in Chapter 2), if terms of trade are: 1 unit of wine =1.1 units of cloth, it is favourable to Portugal but unfavourable to England.

The terms of trade are favourable when they are set closer to the domestic exchange ratio of the opposite country and unfavourable if they are closer to the domestic exchange rate of the country under consideration.

Classical economists, however, affirm that whether, the terms of trade are favourable or unfavourable, all the participating nations gain because under free trade based upon comparative costs advantage, each country is able to import products at lower than their domestic costs.

2. Difference in Cost Ratios

According to Harrod, the gain from international trade depends on the relation between the ratio of the costs of production in the two countries concerned. The gain does not depend on the comparative cheapness of producing commodity X or Y in the two countries.

It depends on the relation between the ratio of the cost of production of X to that of Y in one country and the ratio of the cost of production of X to Y in the other country. Gain is possible if the cost ratios are different in different countries.

Briefly, the gain from international trade arises because of the difference in cost ratios in the production of two commodities in different countries. Say, for example, if in England certain amount of labour produces 10 units of cloth and 5 units of wine, while in Portugal the same quantity of labour produces 5 units of cloth and 15 units of wine, then the labour cost ratio in England is 1:2 and in Portugal 3:1 for producing these two commodities.

Now, when England specialises in the production of cloth and Portugal of wine and trade takes place between these two countries, they both would gain because they will get either cloth or wine cheaply. Suppose, the terms of trade are 1 unit of wine equal to 1 unit of cloth. Portugal by trading with England gets 1 unit of cloth in exchange for 1 unit of wine. Otherwise, in domestic trade it gets only one-third unit of cloth against 1 unit of wine.

Thus, two-third units of cloth more is the gain to Portugal due to international trade. Similarly, England, by trading with Portugal, gets 1 unit of wine in exchange for unit of cloth. In domestic trade, however, it gets only 1/2 unit of wine against 1 unit of cloth. Obviously, 1/2 unit more of wine is England’s gain in international trade.

It is quite obvious that, the gain to the two countries from international trade will be greater when the difference between the cost ratios is greater before trade emerged. However, when trade takes place, each country will be producing more of some goods (having comparative advantage) and less or none of others. This will probably affect the costs of goods in which the country specialises and of others which it curtails.

Hence, new ratios are still different in the two trading countries, gain can be secured by a further expansion of trade, which again affects the cost ratios. Thus, a country would expand or curtail the production of different goods until her ratios of cost are the same as those of the other trading country, resulting in exporting surplus or importing the deficiency so generated.

Here it may be pointed out that in our illustration of England and Portugal, since the cost ratios are unequal, England has a comparative advantage in producing cloth and Portugal has an advantageous position in the production of wine.

Thus, England should push on with the production of cloth until the rise in her cost of producing it and in Portugal’s cost of producing wine and the fall of England’s cost of producing wine and in Portugal’s cost of producing cloth would bring the ratios of their costs to equality. When the cost ratios become equal, as a result of more goods being imported, those goods can better be produced domestically than imported because the prices of different goods in different countries will be the same when the costs ratios are equal.

To recapitulate, we must note that, the size of the gain from international trade depends upon the difference in cost ratios before trade has taken place.

3. Productive Efficiency of the Country

The gain from international trade also depends upon the relative productive efficiency of the country. If the productive efficiency of the home country increases, it will be to the advantage of the foreign country (and vice versa), for it will lead to more favourable terms of trade for the latter.

If the efficiency in producing a commodity in which a country specialises increases, its costs and price fall, and it will be advantageous to the other country. Moreover, it leads to an expansion in the volume of trade, so that, the total gain from trade also increases.

4. Relative Elasticity of Demand

The gain from international trade also depends upon the relative elasticity of demand for the commodities in different countries and the relative elasticity of supply of different commodities in different countries. When exchange takes place as a result of specialisation, the amount of the commodity that will be imported by a country depends not only on the difference in cost ratios but also on how the demand for the commodity changes.

Suppose that before specialisation England was producing 500 units of wine, so that if exchange takes place, England would export 1,000 units of cloth to Portugal and import 500 units of wine. When England stops producing wine, the resources so released would be available for production of cloth which may be 2,000 units. As such, real income increases in England, the demand for wine (if it is elastic then) may also increase to say 800 units, causing more demand for Portugal’s export of wine.

Similarly, Portugal may specialise in wine, it will be able to increase its output of wine, and its demand for England’s cloth may increase (if demand is elastic) as a result of rise in its real income. Thus, as a result of specialisation, real incomes in both the countries rise; hence, gain from trade increases, depending upon the elasticity of demand. More elastic the demand for the commodities in both the countries, the greater would be the volume of trade, output and real income, and larger the total gain.

5. Factor Endowments and Technological Conditions

There exists a positive correlation between the size of foreign trade and the total gain reaped by the participating nations. However, kinds and quality of factors available to a country and its technological advancement has unique significance in this regard.

A big, capital-abundant and technically as well as economically advanced country will have a larger size of foreign trade than a small, labour-abundant, technically and economically backward country. Moreover, a country exporting manufactures will have favourable terms of trade against a country exporting primary products.