Gains from Trade

Figure 8.1 represents a country that does not trade. The (domestic) market equilibrium is given by the quantity demanded, which equals the quantity supplied (QD = QS) at price PD. The net benefits from the rice market (i.e., the net social value to the economy) is the shaded area, which can be divided up into the benefits to consumers, the consumer surplus triangle CS, and the benefits to producers, the producer surplus triangle PS.3

Figure 8.1 represents a country that does not trade. The (domestic) market equilibrium is given by the quantity demanded, which equals the quantity supplied (QD = QS) at price PD. The net benefits from the rice market (i.e., the net social value to the economy) is the shaded area, which can be divided up into the benefits to consumers, the consumer surplus triangle CS, and the benefits to producers, the producer surplus triangle PS.3

Net Social Benefit

■ FIGURE 8.1 Market equilibrium and net social benefit with no rice trade

3See chapter 2 if these terms are unfamiliar.

The domestic market price in this case, PD, is below the world price PW. This means that this country is a potential exporter: at PW producers would be willing to produce more than domestic consumers would be willing to buy. Looking at figure 8.1, we might expect to hear producers complaining that they could get a higher price if they could only export rice at PW. Consumers, on the other hand, would prefer to keep the market domestic, so that they don't have to compete with foreign rice consumers who would pull the price up to PW. When foreign demand is included, the demand curve becomes the "kinked" line DDW in figure 8.2.

If unrestricted trade is allowed in this case, the demand for rice will include foreign demand, which is assumed to be "perfectly elastic" (horizontal) at the world price PW, as shown in figure 8.2. This assumption of perfectly elastic demand is reasonable if the country is small relative to the size of the foreign market. Trading opportunities mean that rice production will rise to meet the foreign demand at PW, which will raise the incomes of producers. Domestic consumers will have to pay more for rice, however, and will therefore consume less (the quantity demanded domestically will now be Q'D while production will rise to equal domestic consumption plus exports, Q'D + QX).

Gain From Trade

■ FIGURE 8.2 Change in net social benefit and gains from rice trade

In this simple case there are three effects of trade. First, producers are made better off because the (shaded) area of PS has increased. Second, consumers are made worse off because the area of CS has been reduced. And third, there are gains from trade because the gains by producers are larger than the losses by consumers. The net benefit or change in total economic surplus is equal to the striped area in figure 8.2 when compared with the original net benefit in figure 8.1.

Now let's look at an example of a country that is a potential importer. In the absence of any trade, the situation will look just like the one in figure 8.1, except that PW will be below PD rather than above it. Let's take the example of trade in bicycles, depicted in figure 8.3. What will happen if the borders are opened and trade is allowed in this case? The effects are similar to the export case, except that this time the winners are the consumers and the losers are the producers. We still expect to see gains from trade: the increase in CS will be greater than the decrease in PS, so that overall economic surplus or net benefits will increase, as indicated by the striped area in figure 8.3.

Gains From Trade Consumers

■ FIGURE 8.3 Domestic market for bicycles with and without imports

In the importing country, trade lowers the price for consumers, allowing them to consume more bicycles, Q'D, and to spend a smaller share of their income on them. Consumer surplus grows larger. By contrast, domestic producers must now compete with foreign bicycle suppliers, meaning that prices drop and some producers leave this industry or reduce the scale of production (moving to Q'S).

Based on these two simple models, the analysis suggests that eliminating barriers to trade will increase net benefits overall, but that for individual markets there will be winners and losers. There is an important realization in this: even if the elimination of trade barriers will generate gains from trade in each of one thousand markets for different goods, there are potentially one thousand interest groups representing either producers or consumers that will have reason to oppose the elimination of trade barriers. Even though trade represents an enlarged range of opportunities for consumers and producers, these added opportunities for some individuals represent threats to other individuals who must now compete with foreigners. Therein lie the incentives for trade barriers and protectionism.

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