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CHAPTER 6
GAINS FROM TRADE IN NEOCLASSICAL THEORY
Learning Objectives:
■ Describe economic equilibrium in a country that has no trade.
■ Discover the welfare-enhancing impact of opening a country to international trade.
I. Outline
Introduction
– The Effects of Restrictions on U.S. Trade
Autarky Equilibrium
Introduction of International Trade
– The Consumption and Production Gains from Trade
– Trade in the Partner Country
Minimum Conditions for Trade
II. Special Chapter Features
In the Real World: Changes in Income Distribution and Welfare with Increased Trade
III. Purpose of Chapter
The purpose of this chapter is to build the case, using familiar microeconomic tools, for a
country to participate in international trade rather than to remain in autarky. The chapter thus
uses more modern or updated analysis, compared to the Classical model, to evaluate the impact
of trade. The chapter also attempts to acquaint the student with some of the important
underlying assumptions in this neoclassical analysis.
IV. Teaching Tips
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D. The consumption gain from trade sometimes puzzles students. It can be useful to explain
this gain as the natural result of receiving a relatively higher price for the good now sold on the
world market, coupled with paying a relatively lower price for the good now bought on the world
market.
E. It can be helpful in discussing the case of identical PPFs and different tastes to emphasize
that the gains for each country occur because they are each getting more of the good for which
V. Answers to End-of-Chapter Questions and Problems
1. Figures 1 and 2 in the text are the relevant diagrams. Point E is the production
equilibrium position because the marginal rate of transformation in production (= marginal cost
of X/marginal cost of Y) is equal to the relative commodity price ratio PX/PY at that point. For
the given relative prices, production at any other point would have PX/PY unequal to MCX/MCY,
or PX/MCX unequal to PY/MCY. Hence, firms would have an incentive to shift resources until
point E was attained.
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2. Yes, the country should trade. It should export cloth because that is the good of
comparative advantage, and producers will have a profit incentive to sell cloth at its relatively
3. The “gains from exchange” (“consumption gain”) occur because of the opportunity to
consume at different relative goods prices, even though production does not change. The higher
4. Yes. Even though unemployment may not fall with the opening of the country to trade,
the country can still be reallocating production (increasing the proportion of employed workers
5. The statement is incorrect. This is the case of trade with a “right–angle” PPF. The
6. Without getting into material generally beyond the scope of the undergraduate course
(such as the conditions discussed in the Tower article cited in the text or in Miltiades
7. This position reflects a misunderstanding of the nature of the gains from trade. With
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trade, both countries become better off in that movement can take place to a higher community
8. It is not likely that trade would cease even if production conditions were to become
9. While the opening of trade improves the overall well-being of a country, it can affect the
distribution of real income and leave certain individuals less well off. This result occurs because
the price of the export good is rising, the price of the import good is falling, and factor prices are
changing. In this case, Ms. Jones is correct about her situation but not about the situation of the
10. Even though a change in the indifference map makes it impossible to compare the new
and old indifference curves in a meaningful way, it is still possible that a conclusion regarding
the gains from trade can be reached by comparing the old consumption bundle with the new
consumption bundle. If a country is consuming more of both goods after trade or the same
VI. Sample Exam Questions
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1. In the equilibrium trading position in a two-country model of trade, why must the trade
triangles of the two countries be congruent (identical)? What role does the slope of the world
price line play in making the triangles congruent?
2. The text has demonstrated that, even if a country’s production does not change with the
opening of the country to trade, a gain (the “consumption gain”) can still occur even though there
is no “production gain.” Is the reverse situation possible – that is, can there be a “production
gain” without there being a “consumption gain” for the country? Why or why not?
3. “In a situation of increasing opportunity costs, trade can be beneficial to both
countries if they have identical PPFs or if they have identical tastes. However,
trade cannot be beneficial to either country if the countries have identical PPFs
and identical tastes.”
Is this statement correct or incorrect? Illustrate and explain.
4. (This question pertains to material in the appendix.) Explain the economist’s distinction,
in discussion of the compensation principle, between “potential” gains from trade and “actual”
gains from trade. Why are the gains only “potential” when that word is used?
5. Suppose that the trade pattern of a country is that it exports foodstuffs and imports fancy
sports equipment. Can you make a case that trade acts like a regressive tax in its impact on the
distribution of real income and welfare within the country? Explain.
6. Explain, using the PPF-indifference curve diagram, how a change in tastes can cause a
7. (a) Using the neoclassical model, build the case why it is beneficial for a country to
move
from a situation of autarky to a situation of free trade.
(b) Briefly, why can the neoclassical model of trade be regarded as “better” in some
respects than the Classical model of trade?
8. Illustrate and explain, for each statement below, why the statement is either TRUE or
FALSE. Assume a two-commodity world in each case.
(a) “If a country has an absolutely fixed production pattern, i.e., resources used
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country cannot experience any welfare gain when moving from autarky to free
trade.”
(b) “It is possible that, even if two countries have identical production–
possibilities frontiers, trade between the countries can enhance the well-being
of each country, in comparison with well-being under autarky.”
9. (a) Suppose that two countries have identical increasing-opportunity-costs production-
possibilities frontiers (PPFs). Illustrate and carefully explain why, under certain
conditions, the two countries can have an incentive to trade with each other. In addition,
illustrate and explain how they can therefore both gain from trade.
(b) Suppose that two countries, in a situation where they each have an increasing-
opportunity-costs production-possibilities frontier (PPF), have identical tastes and
10. (a) Using the neoclassical production-possibilities frontier/indifference curve approach,
build the case that free trade is preferable to autarky for a country. Then explain how an
economist could still say that trade can be beneficial to the country even if trade causes