Gains from Trade Chapter 2 PDF

**Chapter 2: Gains from Trade** The theory of comparative advantage explains why it is mutually beneficial for nation states to allow for international trade. A famous example is trade between England and Portugal. This focus on international trade was obvious in the political atmosphere of the day...

**Chapter 2: Gains from Trade** The theory of comparative advantage explains why it is mutually beneficial for nation states to allow for international trade. A famous example is trade between England and Portugal. This focus on international trade was obvious in the political atmosphere of the days when powerful political forces in England opposed free trade because they feared that they could not compete with Portugal. The theory can explain why people organize economic activities, usually by means of institutions, thus explaining why economics is the study of such institutions. A fundamental aspect of societies, which must cope with scarcity, is that the acts of individuals are interdependent. If a person A eats a sandwich, then B cannot eat the same sandwich; if B wears a red sweater, then A has to look at it, and so on. This **interdependency** can explain the phenomenon of exchange and specialization. The starting point of this endeavor is a situation where **[all individuals in a society abstain from trading goods and services]**, i.e. an individual must produce everything she consumes. This situation is called an ***[autarky.]*** **[Comparative advantage]:** **[the ability to carry out a particular economic activity more efficiently than another nation]**, e.g. at a lower opportunity cost. **[Absolute advantage:]** the ability to produce higher volumes of a good than another nation with the same input. The theory of comparative advantage describes and explains the international trade of goods Usually to illustrate comparative and absolute advantage, one uses production possibility frontiers. These are concave (point out) if productivity is decreasing in production. On diagrams, the absolute advantage is shown by which line reaches the furthest on the axis. The comparative advantage of good X is illustrated by the flattest slope in relation to the X axis. The concept of comparative advantage is relational, because if one nation has comparative advantage in good X, this necessarily implies that the other nation has comparative advantage in good Y. As a result from trade, the increase in production is called the material gains from trade. The (subjective) gains from trade refer to a measure of an increase in well-being. **Disadvantages of trade** In a case of sequential and not simultaneous integration, where a third-party wishes to join into an already formed trade agreement and brings the trade agreement out of balance, for example by one nation dropping the other and switching to the now available third party, the trade agreements may no longer be mutually beneficial. Thus, this can create losers on the way to a fully globalized world economy. Additionally, in the process of specialization, the necessary restructuring of the two economies leads to a loss of jobs in a specific industry, of which the now unemployed population is not comforted by the fact that the whole country is now better off. The restructuring processes in economies usually necessary for trade create winners and losers, and even if the winners could compensate the losers because goods become more abundant, this is rarely done in practice. Small countries could easily be exploited if they are highly dependent on a large, powerful country, and the restructuring of the economy is not easily reversible. This is called a hold-up problem where specialization creates power asymmetries that can be exploited by more powerful trading partners. When a country has a comparative disadvantage it means that has a comparative advantage in the production on another good. This means that an individual is better off through trade because it can specialize in the production of the good that she or he is good at and become better off due to trade. Because specialization implies the division of labor, alienation is also a real problem: the production of goods and services is a means for some underlying end, e.g. happiness. A focus on the materialistic side of production can therefore alienate workers as they feel they are only a little cog in a big wheel, merely a factor of production. This theory was especially important to K. Marx. **Markets as institutions** It is possible to have division of labor and exchange of goods, services and resources without markets. The question of whether markets are a good means to enable specialization and trade must be asked. Specialization and trade are, after all, used to alleviate scarcity. Institutions play a big role in economic theory: they are humanly devised constraints that structure political, economic and social interaction. They consist of informal constraints and formal rules. They provide the incentive structure of an economy; as that structure evolves, it shapes the direction of economic change towards growth, stagnation, or decline. Markets are only one way to organize economic activities, among many others.