The Gains from Trade Principle

Most economic activities involving more than one person are not “zero-sum games”. They involve trading of some kind. Production without consumption is a waste and consumption without production is impossible. This perspective is not isolated to economics. Marketers encourage firms to adopt a “marketing orientation”, in which a firm seeks a profitable strategy which creates value for its customers. Accountants are asked to consider the social benefits associated with an organization by applying the concept of the “Triple Bottom Line”, which accounts for an organization’s profit and its effects on the environment and its effect on its work force. Thoughtful people should expect to see “positive sum games”.

Day 2 of many introductory economics courses teach the lesson of gains from trade due to comparative advantage. The classroom presentation is deceptive simple. Its profound implications are widely misunderstood. A famous economist used this result in reply to a famous mathematician who claimed that the social sciences (i.e., economics, psychology, sociology and others) had little lasting value because they offer no scientific proposition that was both true and non-trivial. The fact that gains from trade are the result of comparative advantage (not absolute advantage nor competitive advantage) is true is demonstrated by the simple classroom example. The fact that gains from trade are the result of comparative advantage is non-trivial is demonstrated by the number of intelligent people who do not believe that it is possible even after the classroom example is explained to them.

This principle is less obvious than some of the other principles of economics because it asks people to expand their view of the question being considered. Ordinary conversations tend to focus on an individual decision maker, especially when people complain that somebody else’s decision was “stupid, mean-spirited and unfair to me”. Ordinary conversations concerning economic issues tend to focus on financial metrics, such as prices and quantities, whereas the idea of gains from trade asks for a broader concept of gains.

A relevant situation considers the effect of a government subsidy. A subsidy seems like a good idea: producer produce more quantity; consumers consumer more; more workers have jobs to produce the increase in output that consumers consume. There is a bit of fiddly stuff concerning the tax revenue used to pay for that subsidy but, maybe, that detail is unimportant. If you think that a small subsidy is a good idea then you may think that a bigger subsidy is even better. The flaw in the logic becomes obvious when the magnitude of the fiddly stuff becomes overwhelming: something in the costs and benefit calculation was overlooked.  Sit is possible to produce too much, either because the cost of production is too high or that the value to buyers is not high enough, or both.

Other examples

Most people take the gains for granted because individual transactions are small and happen everyday. The same potential for gains is often overlooked in other settings. For example,

• eBay: For many decades, there were people willing to sell their junk and other people willing to buy that junk but if the buyer was located fare from the seller then the potential gains from trade were not realized. eBay found a way to profit by overcoming the barriers. (eBay is also an example of how changes in technology produce extra benefits because they enable others to do more.)
• Climate change and collective responsibility. The Science is clear on the negative effects of Climate Change for society. Businesses are aware of the costs of adapting to or reducing the Change. Consumers would be unhappy about paying the financial costs needed to cover the costs which businesses pass on in higher prices. This is a situation with potential benefits to society overall but if it is everybody’s responsibility then nobody will be held accountable. This is a hard problem to resolve because the individuals who need to take action are incentivized to not act. The challenge is to find a way to have the people who “win” by reducing or avoiding Climate Change compensate the people who would “lose” (such as selected businesses, selected consumers and selected workers). This problem in negotiating is hard to solve.
• As a generalization, only one of the two styles of bargaining recognizes the existence of gains from trade. The first style involves pounding on the desk while yelling “I need a better deal”. A more professional style is less likely to have you asked to leave the room. Big deals involve thinking carefully about what the other side wants from the deal and how to craft a “win-win” solution. The former focuses on getting a “bigger share of the cake” while the latter seeks to “make the cake bigger” (a.k.a. gains from trade).

Now, it is your turn to write.

1. Are there any examples of goods or services for which you think that there are unrealized gains from trade. What is the good or service? Do you have any thought on the barrier which prevents finding a mutually beneficial agreement? Do you have any thoughts on the kind of innovation which would be needed to overcome that barrier (i.e., the business opportunity)?

Hint: The best examples are likely to be found where, even if there is an obvious supply curve and an obvious demand curve, the market may be so poorly organized. There may be a willing buyer and a willing seller but, for some reason, that buyer and seller cannot come to an agreement. Without a well-organized market, it takes more work to evaluate costs and benefits in an objective or scientific sense.