Gains from Trade with Increasing Costs
A disparity in relative commodity prices between two nations is a manifestation of their
comparative advantage and serves as the foundation for mutually beneficial trade. The nation
with a lower relative price for a commodity possesses a comparative advantage in that
commodity and a comparative disadvantage in the other commodity, relative to the second
nation.
Consequently, each nation should specialize in the production of the commodity of its
comparative advantage (i.e., producing more of the commodity than it desires to consume
domestically) and exchange a portion of its output with the other nation in exchange for the
commodity of its comparative disadvantage.
However, as each nation specializes in producing the commodity of its comparative advantage, it
incurs escalating opportunity costs. Specialization will persist until relative commodity prices in
the two nations attain equilibrium, at which point trading with each other enables both nations to
consume more than they would in the absence of trade.
Illustrations of the Basis for and the Gains from Trade with Increasing Costs
We have observed that in the absence of trade, the equilibrium relative price of X in Nation 1 is
Pa = ¼, while in Nation 2, Pa’ = 4. Thus, Nation 1 has a comparative advantage in commodity X
and Nation 2 in commodity Y.
Suppose that trade between the two nations becomes possible (e.g., through the elimination of
government obstacles to trade or a drastic reduction in transportation costs).
Nation 1 should now specialize in the production and export of commodity X in exchange for
commodity Y from Nation 2. How this takes place is illustrated by following figure:
Explanation:
Beginning from the equilibrium point in isolation (point A), as Nation 1 specializes in the
production of X and shifts down its production frontier, it experiences rising opportunity costs in
the production of X. This is reflected in the steeper slope of its production frontier. Conversely,
as Nation 2 specializes in the production of Y and moves upward along its production frontier, it
encounters increasing opportunity costs in the production of Y. This is reflected in the flattening
of its production frontier (a decrease in the opportunity cost of X, which implies an increase in
the opportunity cost of Y).
The process of specialization in production persists until the relative commodity prices (the
slope of the production frontiers) attain equilibrium between the two nations. The common
relative price (slope) resulting from trade will lie between the pre-trade relative prices of 1/4 and
4, at the point where trade is balanced. As depicted in Figure, this equilibrium is represented by
Pb = Pb’ = 1.
Through trade, Nation 1 shifts from point A to point B in its production possibilities frontier. By
exchanging 60X for 60Y with Nation 2 (as depicted in the trade triangle BCE), Nation 1 ultimately
consumes at point E (70X and 80Y) on its indifference curve III. This represents the highest level
of satisfaction that Nation 1 can attain through trade at the exchange rate Px/Py = 1.
Consequently, Nation 1 gains 20X and 20Y from its initial equilibrium point. (Compare point E on
indifference curve III with point A on indifference curve I.) The line BE is designated as the trade
possibilities line or simply the trade line, as trade transpires along this line.
Similarly, Nation 2 moves from point A’ to point B’ in production, and by exchanging 60Y for 60X
with Nation 1 (as depicted in trade triangle B’C’E’), it ultimately consumes at point E’ (100X and
60Y) on its indifference curve III’. Consequently, Nation 2 also gains 20X and 20Y from
specializing in production and engaging in trade.
It is noteworthy that with specialization in production and trade, each nation can consume
beyond its production frontier (which also represents its no-trade consumption frontier).
