Chapter 2
Basic Theory of International Trade

Overview

This chapter indicates why we study theories of international trade and presents the basic theory using supply and demand curves. Trade is important to individual consumers, to workers and other factor owners, to firms, and therefore to the whole economy. Trade is also controversial, with perpetual battles over government policies toward trade. To understand all of this, we need to develop theories of why people trade as they do.

It is useful to organize the analysis of international trade by contrasting a world of no trade with a world of free trade, leaving analysis of intermediate cases (e.g., non-prohibitive tariffs) for Part II. The analysis seeks to answer four key questions about international trade:

1. Why do countries trade? What determines the pattern of trade?
2. How does trade affect production and consumption in each country?
3. What are the gains (or losses) for a country as a whole from trading?
4. What are the effects of trade on different groups in a country? Are there groups that gain and other groups that lose?

Theories of international trade provide answers to these four questions.

Basic demand and supply analysis can be used to provide early answers to these four questions, as well as to introduce concepts that can be used in more elaborate theories. Using motorbikes as an example, the chapter first reviews the basic analysis of both demand (the demand curve, other influences on quantity demanded, movements along the demand curve and shifts in the demand curve, and the price elasticity of demand as a measure of responsiveness) and supply (the supply curve, the role of marginal cost, other influences on quantity supplied, movements along the supply curve and shifts in the supply curve, and the price elasticity of supply). It pays special attention to the meaning and measurement of consumer surplus and producer surplus. This section, which focuses on review and development of basic tools, ends with the picture of market equilibrium in a national market with no trade as the intersection of the domestic demand curve and the domestic supply curve.

The remainder of the chapter examines the use of supply and demand curves to analyze international trade. If there are two international markets and no trade, it is likely that the product's price will differ between the two markets. Someone should notice the difference and try to profit by arbitrage between the two markets. If governments permit free trade, then the export supply from the initially low-priced market (the rest of the world in the textbook example) can satisfy the import demand in the initially high-priced market (the United States in the textbook example), and the world shifts to a free-trade equilibrium. We can show this free trade equilibrium by deriving the supply-of-exports curve for the rest of the world and the demand-for-imports curve for the United States. The international market for the product clears at the intersection of the export-supply and import-demand curves, indicating the equilibrium international or world price and the quantity traded. This equilibrium world price also becomes the domestic price in each country with free trade.

The same set of three graphs (the two national markets and the international-trade market) is used to show the effects of the shift from no-trade to free-trade on different groups in each country and to show the net gains from trade for each nation. In the importing country consumers of the product gain consumer surplus and producers of the product lose producer surplus. Using the one-dollar, one-vote yardstick, the country as a whole gains, because the gain in consumer surplus is larger than the loss of producer surplus. In the exporting country producers of the product gain producer surplus and consumers of the product lose consumer surplus. Furthermore, the analysis shows that the country as a whole gains because the gain in producer surplus is larger than the loss of consumer surplus. The country that gains more from the shift to free trade is the country whose price changes more--the country with the less elastic trade curve (import demand or export supply).

Key Terms

Arbitrage: Buying something at a low price in one market and reselling it at a higher price in another market. 

Consumer surplus:  The difference between what a person would be willing to pay and what she actually has to pay to buy a certain amount of a good. It is the area below the demand curve and above the price level.

Producer surplus: The difference between what a producer is paid for a certain amount of a good and the lowest price she requires in order to supply that amount. It is the area above the supply curve and below the price level.

Warm up Questions

True or False? Explain.

1. T / F When trade opens up, all consumers are made better off.

2. T / F In the simple trade model, countries with identical pre trade prices for a good have no incentive to trade in that good.

3. T / F If one producer is made better off by trade, then all producers in a country must be made better off by trade.

4. T / F At the equilibrium trade price between two countries, the excess supply of the good in one country must equal the excess demand for the good in the other country.

5. T / F There ain't no such thing as a free lunch, but there is such a thing as free trade.

Multiple Choice

1. After trade has opened up, the gains that trade brings to consumers of the imported goods are, in absolute value:

            A. Larger than the losses to domestic producers of that good.
            B. Smaller than the losses to domestic producers of that good.
            C. Exactly equal to the losses to domestic producers of that good.
            D. Immeasurable.

2. Which of the following is not likely to promote free trade in lumber between countries?

A. Pre trade lumber prices that are equal across countries.
            B. Profit seeking lumber arbitrageurs.
            C. Lumber supply differences across countries.
            D. Lumber demand differences across countries.

3. Consumer surplus is:

A. What consumers must pay the government to produce goods.
B. What consumers can get below the market price.
C. What it is worth to consumers to be able to buy the product at a price lower than the price some of them would be willing and able to pay.
D. What they can get at all prices.

 4. After trade , the distribution of income in a country changes as:

A. Import competing producers lose while producers of the exportable good gain.
B. The nation as a whole gains while individuals lose.
C. Consumers lose while producers gain.
D. Income flows from consumers to producers.

5. If export supply is less price elastic than import demand, then the:

A. Importing country will not want to trade.
            B. Exporting country will not want to trade.
            C. Exporting country will receive the largest share of the gains to trade.
            D. Importing country will receive the largest share of the gains from trade.

Problems

Consider the graphs of the domestic markets for bread in the hypothetical countries of Leinster and Saxony:

a.         What is the pre-trade equilibrium price of bread in eacg country?
b.         Is there a reason for trade in bread between Leinster and Saxony?
c.         Construct the appropriate import demand and export supply curves, assuming that "the world" consists of only these two countries.
d.         What is the equilibrium trade price of bread in Leinster? In Saxony?
e.         On the domestic market graphs, show that, at the equilibrium trade price, the quantity of bread exported from Saxony equals the quantity of bread importer into Leinster.
f.          On the domestic market graphs, indicate the changes in consumer and producer welfare which result from trade opening in each country.
g.         Which groups in the two countries will be happy with free trade in bread between the countries? Which groups will wish free trade would be banned?
h.         On your "international" graph with the export and import curves, indicate the net gains from trade for each country.
i.          Which country gains the larger share from trade? Why? (Hint: Look at the elasticities of the trade curves you derived.)
j.          Indicate the losses each country would incur if trade in bread were eliminated.

2.         Assume that, for an unknown reason, both the domestic supply of and the domestic demand for bread in Leinster become very elastic, while the curves for Saxony are unchanged. What impact would this have on the international price, the quantities traded and the net gains from trade for Leinster and Saxony?

3.         U.S. lumber companies make 52 billion board feet of lumber each year, of which billion board feet are exported and 42 billion are sold in the United States. The average price is 30 cents per board foot. If lumber exports were banned by law, production (now for the domestic market only) would be 48 billion board feet, and the price would drop to 25 cents perboard foot. How much producer surplus would U.S. lumber producers lose each year as a result of the export ban?

4. Suppose that opening up trade would make our nation export beans and import jeans. Let's say that it raises the price of beans from 0.20 jeans/bushel (so that jeans drop in price from 5 bushels of beans to 4 bushels).

a.         What are the welfare effects of trade on bean consumers, bean producers, jeans consumers, and jeans producers?

b.         Will the opening of trade bring a net national gain? How do you know?

c.         Describe how to measure the net national gain or loss (measured in units of real goods) from the opening of trade.

Discussion Topics

1 .         What ways of measuring welfare can you think of besides the "one dollar, one vote" yardstick?

2.         Is profiting from arbitrage in commodities a good or a bad thing?

3.         What might motivate trade between two countries other than price differentials?

4.         Using the ideas of consumer and producer surplus, try to formulate an argument for avoiding a (trade) war between two countries.