Question

Consider two identical countries, country A and country B, that both produce shampoo, a good characterized by product differentiation, with identical increasing returns to scale technology. Each variety of shampoo is produced by a different firm, so the market exhibits all the characteristics of the monopolistic competition model of trade.

1. In the free trade, describe the gains from trade in country A and country B. How are the gains from trade different from trade based on comparative advantage?

2. If two countries allowed to trade what can you say about the income distribution effects of trade?

Answer 1

Ans. 1) In Free trade , both the countries can gain in the following ways :

a) National Income of the countries would increase because of trade.

b) The country having excess production would benefit by increase in exports.

c) The country having lower production would benefit by imports ( Consumer Benefits ) .

d) Free trade would benefit the producers and consumers of both the countries.

These gains are different from comparative advantage because when trade is done according to comparative advantage , then the country producing Shampoo at a lower opportunity cost would export shampoo to the other country.

2. If countries are allowed to trade with each other, Economic growth of both the countries would prosper and this would lead to more profitability and even improvement in infrastructure. If both the countries are identical , then the income distribution effects would nearly be same but can vary depending on other factors.

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