International Trade: Small Country Basics

1. International Trade: Small Country Basics Udayan Roy http://myweb.liu.edu/~uroy/eco41 September 2006

2. Questions • What determines whether a country imports or exports a good? • Who gains and who loses from free trade among countries? • What are the arguments that people use to advocate trade restrictions?

3. Equilibrium Without Trade • Assume: • A country is isolated from rest of the world and produces steel. • The market for steel consists of the buyers and sellers in the country. • No one in the country is allowed to import or export steel.

4. Domestic supply Consumer surplus Equilibrium Producer price surplus Domestic demand Equilibrium quantity Figure 1: The Equilibrium without International Trade Price of Steel 0 Quantity of Steel

5. The Equilibrium Without International Trade • Domestic price adjusts to balance demand and supply. • The sum of consumer and producer surplus measures the total benefits that buyers and sellers receive.

6. The World Price and Comparative Advantage • If the country decides to engage in international trade, will it be an importer or exporter of steel?

7. The World Price and Comparative Advantage • The effects of free trade can be shown by comparing the domestic price of a good without trade and the world price of the good. • The world pricerefers to the price that prevails in the world market for that good.

8. The World Price and Comparative Advantage • If a country’s domestic price of a product is below the world price • the country is said to have a comparative advantage in the production of this product, and • this country will be an exporter of the good.

9. The World Price and Comparative Advantage • If a country’s domestic price of a product is above the world price • the country does not have a comparative advantage in the production of this product, and • this country will be an importer of the good.

10. Domestic Price supply after trade World price Price before trade Domestic Exports demand Domestic Domestic quantity quantity demanded supplied Figure 2 International Trade in an Exporting Country Price of Steel 0 Quantity of Steel

11. Domestic supply Price Exports after A trade World D B price Price before C trade Domestic demand Figure 3 How Free Trade Affects Welfare in an Exporting Country Price of Steel 0 Quantity of Steel

12. Consumer surplus before trade Domestic supply Price Exports after A trade World D B price Price before C trade Producer surplus before trade Domestic demand Figure 3 How Free Trade Affects Welfare in an Exporting Country Price of Steel 0 Quantity of Steel

13. How Free Trade Affects Welfare in an Exporting Country

14. The Winners And Losers From Trade • For an exporting country: • Domestic producers of the good are better off, and • Domestic consumers of the good are worse off. • Trade raises the economic well-being of the nation as a whole. That is, the gain to producers exceeds the loss to consumers.

15. International trade in an importing country • If the world price of steel is lower than the pre-trade domestic price, the country will be an importer of steel when trade is permitted. • Domestic consumers will be able to buy steel at the lower world price. Therefore, • Domestic consumers will increase their consumption • Domestic producers of steel will have to lower their prices to compete • Domestic producers will reduce production. • The excess of domestic consumption over production will have to be imported

16. Domestic supply Price before trade Price World after price trade Domestic Imports demand Domestic Domestic quantity quantity supplied demanded Figure 4 International Trade in an Importing Country Price of Steel Quantity 0 of Steel

17. Domestic supply A Price before trade B D Price World after trade price C Imports Domestic demand Figure 5 How Free Trade Affects Welfare in an Importing Country Price of Steel 0 Quantity of Steel

18. Consumer surplus before trade Domestic supply A Price before trade B Price World after trade price C Producer surplus before trade Domestic demand Figure 5 How Free Trade Affects Welfare in an Importing Country Price of Steel 0 Quantity of Steel

19. Consumer surplus after trade Domestic supply A Price before trade B D Price World after trade price C Imports Producer surplus after trade Domestic demand Figure 5 How Free Trade Affects Welfare in an Importing Country Price of Steel 0 Quantity of Steel

20. How Free Trade Affects Welfare in an Importing Country

21. The Winners And Losers From Trade • How Free Trade Affects Welfare in an Importing Country • Domestic producers of the good are worse off, and • Domestic consumers of the good are better off. • Trade raises the economic well-being of the nation as a whole because the gains of consumers exceed the losses of producers.

22. The Winners And Losers From Trade • Irrespective of whether a country exports a good or imports it, the gains of those who gain exceed the losses of those who lose. • That is, the net change in total surplus is always positive.

23. Gains From Trade • The gains from trade can be expressed as the sum of • the gains from exchange, and • the gains from specialization.

24. Gains From Exchange • Free trade will lead to gains even for a country whose production levels, for whatever reason, remain what they were in autarky. These gains are called the gains from exchange.

25. Gains From Specialization • Typically, however, free trade also leads to changes in production levels as a nation becomes more specialized in the production of the good in which it has a comparative advantage. The gains due to this specialization in production are called the gains from specialization.

26. Domestic supply Price Exports after A trade World D B price Price before C trade Domestic demand Exporting Country Price of Steel D = gains from trade 0 Quantity of Steel

27. Price after A trade World D B price Price before C trade Domestic demand Gains From Exchange Price Domestic Supply of Steel Exports D = gains from exchange 0 Quantity of Steel

28. Domestic supply Price Exports after A trade World D B price Price before C trade Domestic demand D = gains from exchange; E = gains from specialization; D + E = total gains from trade Price of Steel E 0 Quantity of Steel

29. Opposition to Free Trade • Free trade need not benefit every citizen of a country • Free trade may be opposed by those who stand to lose from trade • The gains of those who gain (which, after all, exceed the losses of those who lose) can be used to compensate those who lose from trade • If this is done, everybody would support free trade

30. The Lessons for Trade Policy • Other benefits of international trade • Increased variety of goods • Lower costs through economies of scale • Increased competition • Enhanced flow of ideas

31. Common Arguments For Restricting Trade • Jobs • National Security • Infant Industry • Unfair Competition • Protection-as-a-Bargaining Chip