Gains from trade

Van Rensburg et al., chapter 18, pp. 419-426

Professor Corné van Walbeek

February/March 2025
 The rationale for free
trade has a long history
• Adam Smith (1776):
• “It is the maxim of every prudent master of a family,
never to attempt to make at home what it will cost
him more to make than to buy...What is prudence in
the conduct of every private family, can scarce be folly
in that of a great kingdom
• “If a foreign country can supply us with a commodity
cheaper than we ourselves can make it, better buy it
of them”
• “Trade is what makes a nation wealthy,
trade restrictions make us poorer”
 The economic basis for
trade
• Natural, human and capital resources are unevenly
distributed around the world
• The production of various goods requires different
technologies or combinations of resources
• Product differentiation, in terms of quality and
non-price attributes
• Examples:
• Strawberry production requires land, appropriate climate and
lots of (unskilled) labour
• Car production requires capital (i.e. machines) and skilled labour
• Platinum mining requires ore deposits (and capital and labour)
 The economic basis for
trade (cont.)
• Production can be
• Land (natural resource) intensive (e.g. mining and
agriculture)
• Capital intensive (e.g. cigarettes)
• Labour intensive (e.g. clothing)

• Countries’ distribution of resources, technology

and product distinctiveness can change over time
• E.g. South Africa: no longer dominant in gold
• China: moved from labour-intensive products to hi-
tech products
 Comparative advantage

• Two people
• Accountant Alindile: earns R1000 per hour as
accountant; can paint the house in 30 hours
• Painter Mason: earns R150 an hour as painter; can
paint the house in 40 hours
• Should Alindile paint the house?
• She has an absolute advantage in painting (30 hours vs. 40
hours)
• Opportunity cost = R30 000 (30 hours x R1000/hour)
• Cost to have Mason paint the house = R6 000 (40 hours x
R150/hour)
• What should she do?
 Comparative advantage
(cont.)
• Mason requires 20 hours to do the tax returns
• Alindile can do it in two hours
• What should Mason do?
• Opportunity cost for Mason is R3 000 (20 hours x
R150/hour)
• Cost to employ Alindile = R2000 (2 hours x
R1000/hour)
• What should Mason do?
 Absolute and
comparative advantage
• Who has absolute advantage in painting?
• Who has absolute advantage in accounting/tax
services?
• Who has relative advantage in painting?
• Who has relative advantage in accounting/tax
services?

• The same principles apply to countries as well

 A country example

• Two countries: Zambia and Malawi (of similar size)

• Two products: Meat and maize
• Using all its resources, Zambia can produce either 30
units of meat or 30 units of maize, and any linear
combination of the two
• Malawi can produce either 20 units of meat or 10
units of maize, and any linear combination of the two
• Present the PPFs of these two countries graphically
• Have maize on the horizontal axis
 Graphically
Zambia has a higher standard of living because it
produces a lot more resources with the same resources
that Malawi has
Meat Meat
Zambia Malawi
30

PPF
20

PPF

30 10
Maize Maize
 A side comment

• The PPFs are drawn as straight lines

• Assumption: constant opportunity cost
• Resources are equally productive in the production in
meat and maize production
• Assumption of increasing opportunity cost is
discarded
• This assumption simplifies the issue
• One can have the assumption of increasing
opportunity costs, but it makes the analysis more
complex (see text, p. 426)
 Some questions

• Which country has a higher standard of living?

• Which country has absolute advantage in meat?

• Which country has absolute advantage in maize?

• Is there a rationale for trade between them?

 Comparative advantage

• What is the opportunity cost (in terms of meat) of

an additional unit of maize:
• In Zambia?
• In Malawi?

• Which country can produce maize cheaper?

• Which country has a comparative advantage in

producing maize?
 Comparative advantage
(cont.)
• What is the opportunity cost (in terms of maize)
of an additional unit of meat:
• In Zambia?
• In Malawi?

• Which country can produce meat cheaper?

• Which country has a comparative advantage in

producing meat?
 The bottom line

• Even though Malawi does not have an absolute

advantage in the production of either product, it
has a comparative advantage in the production of
meat
• Malawi can produce meat relatively cheaper than
Zambia
• Malawi should specialize in the production of meat
and Zambia should specialize in the production of
maize
• Malawi should export meat and import maize
• Zambia should export maize and import meat
 How will trade make
both countries better off?
• Each country to specialize in the product in which
it has a comparative advantage
• The countries need to negotiate an international
exchange ratio (terms of trade)
• Assume that they agree to 1 Maize = 1.5 Meat
• (We will explain this in more detail later)
• So, 10 units of maize will be exchanged for 15
units of meat
 How will trade make
both countries better off
Country Output Output Exports Consump- Gains
before
special- after and tion after from
ization special- imports trade special-
Autarky an economic
ization ization &
system of self- trade
sufficiency and limited
Zambia 18 maize
trade 30 maize -10 maize 20 maize 2 maize
12 meat 0 meat +15 meat 15 meat 3 meat
Malawi 8 maize 0 maize +10 maize 10 maize 2 maize
4 meat 20 meat -15 meat 5 meat 1 meat
World 26 maize 30 maize 30 maize 4 maize
16 meat 20 meat 20 meat 4 meat
 Presenting this
45
graphically
Meat Meat
Zambia Malawi
30 Trading
possibilities
line
Trading
PPF 20 possibilities
(20;15) line

PPF
(18;12) (10;5)
(8;4)

30 10 13.33
Maize Maize
 The terms of trade
THE STRENGTH OF THE SUPPLY AND THE STRENGTH OF THE DEMAND

• The international exchange ratio (terms of trade)

will lie between the two domestic exchange
ratios
• Zambia: 1 maize = 1 meat
• Malawi: 1 maize = 2 meat
• The international terms of trade is determined by the
supply and demand for the two products
• If Zambia is desperate for meat, the international terms of
trade will be something like 1 maize = 1.1 meat
• If Zambia does not care much for meat, the TOT will be
something like 1 maize = 1.8 meat
• If Malawi is desperate for maize, it is willing to give a lot of
 Another, different
example
• Two countries: Mali and Niger
• Two products: Camels and dates
• Maximum production of these two products if all resources are applied to each
product
Camels Dates (tons)
Mali 400 2000
Niger 800 1000
• Assume constant opportunity costs in each country
 Questions and
instructions
• Which country has absolute advantage in:
• Camels?
• Dates?
• Draw the PPFs for the two countries
• What is the opportunity cost (domestic exchange
ratio) of an additional camel in:
• Mali?
• Niger?
• Between which two exchange ratios will the
international terms of trade lie?
 More questions and
instructions
• If Niger has a very strong demand for dates and
Mali does not have a strong demand for camels,
which of the following three international
exchange ratios (terms of trade) is most likely?
• 1 camel = 1.25 tons of dates
• 1 camel = 1.5 tons of dates
• 1 camel = 2.5 tons of dates
• 1 camel = 4 tons of dates
• Draw the trading possibilities line on the PPF and
show that international trade will make both
countries better off
 Even more questions and
instructions
On the PPF graph, the new slope will be -2.5 the trading possibilitie
s line

• If the international terms of trade is negotiated at 1

camel = 2.5 tons of dates, show how this will affect
the trading possibilities line
• Choose a (random) point of consumption on the
original PPFs of the two countries and then indicate
the new point of consumption on the trading
possibilities line
• Important: the exports of commodity X of one country is
equal to the imports of commodity X of the other
country
• Show how many camels will be traded for dates in
 The gains from trade

END OF THIS SECTION