The Benefit of Trade

Trade is beautiful. People cooperating. Voluntary. Peaceful. Everyone exchanging something they value less highly for something they value more highly. These are some of the ideological reasons people love trade, but what about the tangible reasons?
Here is one way to explain the gains from trade without relying on ideology.
Situation 1 is an America that doesn’t trade. We’re going to look at two goods America can produce. I’ve called them Good A & B but they could be snowboards & skis… or guns & butter.
The curve in Situation 1 is called a “Production Possibility Frontier.” America can produce any combination of Goods A & B along that frontier, but cannot produce beyond it. The American consumer, without access to foreign markets, prefers to consume at Point A1 & B1. So, we draw a trade line tangent to that point:
Next, let’s add 3 possible indifference curves:
Situation 2: Now America begins trading with foreign countries. When this happens the trade line rotates on its axis. It is still touching the Production Possibility Frontier, but now we can reach a higher indifference curve:
So what does this show us? Once trade begins Americans discover that Good A is cheaper overseas. Americans start consuming more of the cheap Good A and start consuming less of Good B. (Americans are consuming at the blue point, but still producing at the original green point).
Situation 3: After opening up trade, domestic production will adjust in response to the changes in demand described above. Americans start producing less of Good A (which was cheaper internationally) and start producing more of Good B. On our graph that is expressed as a movement along the Production Possibility Frontier to the final purple point. America ultimately produces Good A at point A4 & Good B at point B4. Knowing this we draw a new trade line tangent to that purple point, which depicts America’s new level of domestic production. This new trade line allows Americans to reach the third & highest indifference curve. The difference between what Americans consume & what they produce are, of course, our imports & exports respectively:
Now …. did you see what happened? Here’s the important part…. this is the gain from trade. Look back at where Americans were consuming in Situation 1 before trade, and where they’re consuming now in Situation 3 after trade:
After trade Americans can now consume more of BOTH Goods A & B. That is the magic of trade, and it is a practical benefit not just ideological preference.
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Rick Kelo March 3, 2015 , 8:36 am Vote2
Trade is an interesting topic among economists. Many will shun a priori deductive reasoning in other areas of economics, but when asked why they all favor free trade it is because of a priori deduction about advantages.
The other thought I’d add: The example in this article shows you why even unilateral trade liberalization (where your nation reduces trade barriers without a similar commitment from your trading partners) is beneficial. Hong Kong is one obvious example of how that works out. In fact, trade agreements create their own distortions & inefficiencies that wouldn’t exist if one country unilaterally lowered trade barriers to all its trading partners not just select countries.
Peter L March 3, 2015 , 10:21 am Vote1
Very interesting indeed! I always wondered what would happen if Canada (where I live) did away with trade restrictions. I wondered if our industry wouldn’t go belly up since people would buy elsewhere.
Of course Canada, the US or whoever could also do away with restrictions in their own country that makes business more expensive and that would help make good cheaper to produce.
Rick Kelo March 3, 2015 , 10:29 am Vote1
That’s a great question and it is also the #1 most common objection to trade. Job outsourcing…. off-shoring… or other variations of that theme. When it comes to that aspect the total number of jobs will not change. Trade is never about how many jobs there are going to be… it’s about which jobs. So if Canada dropped all trade barriers jobs would naturally, and gradually, migrate out of import industries into export industries. However, the total number of jobs wouldn’t change.
The other thought I’d offer is this. Jobs in export industries are the better paying so everyone benefits over time if employment gradually shifts into those sectors. On balance the Canadian citizen, in their capacity as a producer of 1 good, is benefited by trade liberalization. I can’t speak declaratively for Canada so I’ll use America as an example. In the US we have studies going back 20 years that have found jobs in our export industries pay 5% – 15% more than the median wage (depending on the year).
Peter L March 3, 2015 , 10:41 am
That makes sense to me. Canada’s biggest industry might be oil. The best paying jobs are all in Alberta where the oil is! Oil is an export industry. @rickkelo