The gains from international trade arise because of the diversity in the conditions of production (natural or acquired) in different countries. Each country tries to specialize in the production of those commodities in which its comparative cost advantage is greatest or the comparative disadvantage is the least. It realizes gain by exporting those commodities which it has a relative advantage over other countries.
The gain from international trade can arise only if the opportunity cost ratio between two commodities is different. If the substitute ratio is the same, no advantage can occur to any country. This can be illustrated by taking numerical examples.
(1) Equal Difference in Substitute Ratio: Let us suppose in Pakistan one unit of productive resources produces either one quintal of cotton, or half quintal of wheat. Suppose further that India, with one unit of resources is also able to produce either one quintal of cotton or half quintal of wheal. Will specialization or exchange be of any advantage to India and Pakistan? The answer is No. If Pakistan and India invest two units of productive resources separately in their own countries, the total production will be:
Pakistan: 1 quintal of cotton + 1/2 quintal of wheat.
India: 1 quintal of Cotton + 1/2 quintal of wheat.
Total product = 2 quintal of cotton + 1 quintal of wheat without specialization.
If Pakistan specializes in the production of cotton and India in wheat the total production will be:
Pakistan: 2 quintals of cotton.
India: 1 quintal of wheat.
When the opportunity cost ratio between two countries is the same, no benefit can occur through specialization to the countries concerned. If Pakistan specializes in the production of cotton and India in wheat, Pakistan will gain only if she can get more than 1/2 quintal of wheat for one quintal of cotton from India.
India won’t agree to it because in her own country she can get one quintal of cotton for 1/2 quintal of wheat, India can only gain if she pays less than 1/2 quintal of wheat for one quintal of cotton to Pakistan.
To this bargain, Pakistan won’t agree because by transferring productive resources from cotton to what she can produce that much at home. Thus, we find, that when comparative cost ratio between two countries is the same, no gain can arise from international trade.
(2) Difference in Comparative Cost Ratio: When comparative cost ratio in two countries differs, then gain arises from international trade, let us suppose now that with one unit of resource Pakistan produces either one quintal of cotton or 10 quintals of wheat. India with the same resources produces either one quintals of cotton or 25 quintals of wheat. If Pakistan and India invest their resources in their own countries separately for the production of cotton and wheat, the total production will be:
Pakistan: 1 quintal of cotton + 10 quintal of wheat.
India: 1 quintal of cotton + 25 quintal of wheat.
Total = 2 quintals of cotton + 35 quintals of wheat.
If Pakistan specializes in the production of cotton and India in wheat, the total product with the same productive resources will be:
Pakistan: 2 quintals of cotton.
India: 50 quintal of wheat.
We find thus that when opportunity cost ratio is different between two countries, the same productive resources can be made to yield a surplus of 15 quintals of wheat. This surplus of 15 quintals of wheat can be mutually shared by Pakistan and India. If Pakistan’s demand for India’s wheat is inelastic, terms of trade will be more in India’s favor. In case Pakistan’s demand for wheat is elastic, then the terms of trade will be more in its favor.
Similarly, if India’s demand for Pakistan’s cotton is inelastic, the terms of trade will move against India. Let us now go back to actual exchange. If Pakistan’s demand for India’s wheat is inelastic, the rate of exchange will settle somewhere near 11 quintals of wheat for one quintal of cotton and if India’s demand for Pakistan’s cotton is inelastic, then the rate of exchange will settle somewhere near 24 quintals of wheat for one quintal of cotton. The actual rate of exchange will settle on the intensity of reciprocal demands, and it will remain within two extreme limits, i.e., 10 and 25 quintals.
In our example given above, the difference in the cost ratio is small therefore, the gain enjoyed by the trading countries is not much. The greater the difference in the cost ratio, the larger is the total gain.
In the words of Harrod:
“A country gains by foreign trade if and when the traders find that there exists abroad a ratio of prices very different from that to which they are accustomed at home. They buy what to them seems cheap and sell what to them seems dear. The bigger the gap between what to them seems low point and high point and the more important the article affected, the greater will be the gain from trade. Prof. Ohlin, on he other hand, is of the opinion that the amount of gain from international trade is very complicated. He doubts if the gain from international trade will at all be measured although he does not doubt the existence of such gains”.