How Gains from Foreign Trade Depends on the Size of a Country?

In a relative sense, larger the country smaller would be the gains from trade and the smaller the country larger would be the proportion of gains enjoyed.

A large country’s resources are well- utilised with the economies of scale on account of big domestic market and its labour is more efficient comparatively on account of technical improvements, so the domestic production costs of practically all goods will be lower as compared to other small countries.

Hence, its domestic prices will not be very different from the world market prices. Gains from trade will be large only when domestic exchange ratios are very high as compared to the international exchange ratios of goods. But, for a large and economically well-advanced country, when it dominates the world market as well its domestic exchange ratios at the most will only slightly differ from the world exchange ratio then, there is hardly any differential gains realised from foreign trade by such a country.

On the other hand, the small country has a limited domestic output and when it enters into foreign trade its import will be comparatively less than what it will export to the big country. Eventually, the terms of trade will tend to be in favour of the small country.

Again, its domestic exchange ratio will be much higher than the world market prices of goods traded. Hence, when it specialises in certain goods on the basis of comparative cost advantage, and imports rest of the goods at a much lower price from other countries (than what it would have cost, if produced domestically); it certainly reaps a larger gain by entering into the foreign trade.

To demonstrate that relatively a small country gains more than a large country when both enter into trade, we may adopt Professor Heller’s model.

Country I is assumed to be the large one and country II is assumed as the small one. Both produce at constant opportunity cost of production. Thus, AB is &e production possibility curve of country I and CD is the production possibility curve of country II for two goods X and Y. Before trade, the large country (I) is assumed to produce and consume at point P, which is the tangency point between the production possibility curve AR and the community indifference curve (CIC ). Similarly, the before trade equilibrium position of country II is at point Q.

When trade occurs between these two countries, let us assume that international terms of trade is equal to the domestic terms of trade of the large country (I). Apparently, no benefit is reaped by the country I through foreign trade as there is no difference between the world market prices and the domestic prices of goods prevailing in the country.

In case of the small country (II), when it trades along TD terms of trade (TD/AB), it will completely specialise in the production of X and produce up to point D. It exports X and imports Y from country I. It thus, reaches a new equilibrium position under foreign trade at point R, and thereby attains a higher community indifference curve 0CIC’) indicating a higher level of satisfaction.

Eventually, SD is the export of X by the country 1 which is the import of X= GP by country II. Similarly, country II exports Y= HG to country I which is equal to the latter’s import measured as RS. It appears that, the large country has to modify its production pattern at point H just to have a trade relation with the small country. The model depicts that the large country reaps no gains from the foreign trade, while the small country enjoys all benefits.

This is just a theoretical extreme case based on the following constraints: (i) there is constant returns to scale, so constant costs conditions, and (ii) the resulting demand pattern modifies the terms of trade for the small country only, while the market and domestic terms of trade for the large country remain the same.

But, if there is decreasing returns or increasing costs condition and different demand pattern exist, the international terms of trade will be set between the domestic exchanges ratios of two countries, and then both the countries will gain.

As Professor Heller puts, “the proportion of the benefits accruing to each country depending on how much the international terms of trade change from the pre trade price ratios. Chances are that these price changes are more pronounced in the small country and that therefore most of the gains accrue to its residents.”