Page 39 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 3 : Free Trade Theory — Absolute Advantage, Comparative Advantage and Opportunity Cost

trade transacting is completed, Malaysia will have 30 units of textiles plus 40 units of rubber for Notes
its own consumption. Compare India’s post-trade consumption of the two commodities in
Table 9 (viz. 90 + 40) with their pre-trade levels in Table 7 (viz. 80 + 40), and you will notice a net
consumption gain of 10 units (in terms of its own product, textiles. This is shown in the last
column in Table 9. Similarly, compare also Malaysia’s post-trade consumption of the two
commodities in Table 9 (viz. 30 + 40) with their pre-trade levels in Table 7 (viz. 20 + 40) you will
once again see that Malaysia’s net trading gain in terms of consumption has been equal to that of
India i.e. 10 units (also in terms of India’s product, textiles). Both countries have gained equally in
terms of consumption (viz. by 10 units each), and this is shown in the last column in Table 9.
In this particular case, note two things—(a) World production gain of 20 has resulted entirely
from the production gain in Malaysia, and the production gain has been in terms of Malaysia’s
product, viz. rubber; (b) consumption gain for the two countries, 10 each for India and Malaysia,
has been in terms of India’s product, viz. textiles. What is important, however, is that although
production gains have gone up only for Malaysia, the consumption gains are distributed equally
between Malaysia and India. This is due to equitable terms of trade which are at a point exactly
mid-way between the internal cost ratios in India and Malaysia. Note also that there has been
complete specialization in both the countries : India produces only textiles using all the available
economic resources in the country, and Malaysia produces all the rubber it can, by using all of
its resources for rubber production alone. There is full employment in both countries, since all
economic resources are fully utilized in the production of goods, International specialization
has been extreme and complete.
2. If the international terms of trade are 1:2 (i.e. where one unit of textiles will be exported in
exchange for 2 units of rubber on the international market), then all the consumption gains
would go to India; because these terms of trade are equal to the internal cost ratio in Malaysia.
In this situation, therefore, the cost of importing one unit of textiles would be the same as the
cost of producing it domestically in Malaysia. As a result, Malaysia would gain nothing from
the standpoint of consumption, even though the production gains have taken place only in
Malaysia. Table 10 illustrates this possibility below :
Table 10 : Consumption Levels after International Trade

Commodities Total Gains in
Countries Textiles Rubber Consumption Consumption
(units) (units) (units) (units)
India 100 40 140 20
Malaysia 20 40 60 0

World 120 80 200 20

India produces 120 units of textiles, keeps 100 units for its own home consumption and exports 20
units to Malaysia. At international terms of trade of 1:2, India would import 40 units of rubber in
exchange for 20 units of textile exports to Malaysia. Thus, India’s post-trade consumption
combination of textiles and rubber would be 100 plus 40, and that of Malaysia 20 plus 40 (as in
Table 10). Compare these figures with the pre-trade consumption levels in the two countries (in
Table 7) and you will see that India’s consumption gain is equal to 20 and that of Malaysia equal
to zero, after the establishment of trade between them. All the production gains (i.e. of 20 units)
arising out of specialization in Malaysia have gone over to India in the form of consumption gains
(of 20 units). Malaysia has, so to speak, all the production gains, and India gets all the consumption
gains. In Malaysia, as in India, production has been more specialized after trade; and in fact there
has been extreme or complete specialization in Malaysia (as well as India) But in spite of production
specialization, Malaysia gains nothing from trade, measured in terms of consumption or living
standards. Malaysia’s failure to get a share in the consumption gains from trade results from
terms of trade which are extremely unfavourable to Malaysia. This, once again, underlines the

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