2.2: Economic value is created by ‘gains from trade’—realised through transactions
Economic value is created when individuals, businesses or organisations transact with each other. Specialisation allows businesses to focus on producing specific goods or services, based on what they are better at. Put another way, parties can be made better off if they exchange something that they are relatively better at producing for something that the other party has the ‘comparative advantage’ in.The original ideas of ‘division of labour’, ‘comparative advantage’ and ‘gains from trade’ are generally attributed to the classic works of Adam Smith and David Ricardo. These concepts … Continue reading For example, the production of a car will involve designing the car, building the engine, and adding in many other components. However, the same firm is (in general) unlikely to be sufficiently specialised in the production of all elements of a car to be able to design and manufacture these within the same organisation as successfully as (i.e. to the same quality or at the same price) if they traded with firms who specialise in a particular activity. Therefore, firms (and individuals) specialise and trade between themselves to meet each other’s needs.
This specialisation leads to a more efficient allocation of resources since people and businesses focus on areas in which they can be most productive. As a consequence, there is an increase in productivity throughout the economy (for instance, as businesses and people become more skilled in particular activities), and total economic output correspondingly increases.
Such specialisation, however, will only occur if businesses can trade their surplus output in exchange for other goods and services. These ‘gains from trade’ are realised through transactions.
|The original ideas of ‘division of labour’, ‘comparative advantage’ and ‘gains from trade’ are generally attributed to the classic works of Adam Smith and David Ricardo. These concepts continue to underpin the academic rationale behind trade between countries—e.g. see DfIT (2020), ‘Final Impact Assessment of the Agreement between the United Kingdom of Great Britain and Northern Ireland and Japan for a Comprehensive Economic Partnership’, section 5.1.