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International Trade: Small
Country Basics
Udayan Roy
http://myweb.liu.edu/~uroy/eco41
September 2006
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?
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.
Figure 1: The Equilibrium without International Trade
Price
of Steel
Domestic
supply
Consumer
surplus
Equilibrium
price
Producer
surplus
Domestic
demand
0
Equilibrium
quantity
Quantity
of Steel
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.
The World Price and Comparative
Advantage
• If the country decides to engage in
international trade, will it be an importer or
exporter of steel?
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 price refers to the price that prevails
in the world market for that good.
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.
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.
Figure 2 International Trade in an Exporting Country
Price
of Steel
Domestic
supply
Price
after
trade
World
price
Price
before
trade
Exports
0
Domestic
quantity
demanded
Domestic
demand
Domestic
quantity
supplied
Quantity
of Steel
Figure 3 How Free Trade Affects Welfare in an
Exporting Country
Price
of Steel
Price
after
trade
Domestic
supply
Exports
A
B
Price
before
trade
World
price
D
C
Domestic
demand
0
Quantity
of Steel
Figure 3 How Free Trade Affects Welfare in an Exporting Country
Price
of Steel
Consumer surplus
before trade
Price
after
trade
Exports
A
B
Price
before
trade
World
price
D
C
Producer surplus
before trade
0
Domestic
supply
Domestic
demand
Quantity
of Steel
How Free Trade Affects Welfare in an
Exporting Country
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.
International trade in an importing country
– If the world price of steel is lower than the pretrade 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
Figure 4 International Trade in an Importing Country
Price
of Steel
Domestic
supply
Price
before
trade
Price
after
trade
World
price
Imports
0
Domestic
quantity
supplied
Domestic
quantity
demanded
Domestic
demand
Quantity
of Steel
Figure 5 How Free Trade Affects Welfare in an Importing Country
Price
of Steel
Domestic
supply
A
Price
before trade
Price
after trade
B
C
D
Imports
World
price
Domestic
demand
0
Quantity
of Steel
Figure 5 How Free Trade Affects Welfare in an Importing Country
Price
of Steel
Consumer surplus
before trade
Domestic
supply
A
Price
before trade
Price
after trade
B
World
price
C
Producer surplus
before trade
0
Domestic
demand
Quantity
of Steel
Figure 5 How Free Trade Affects Welfare in an Importing Country
Price
of Steel
Consumer surplus
after trade
Domestic
supply
A
Price
before trade
Price
after trade
0
B
C
D
Imports
Producer surplus
after trade
World
price
Domestic
demand
Quantity
of Steel
How Free Trade Affects Welfare in an
Importing Country
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.
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.
Gains From Trade
• The gains from trade can be expressed as
the sum of
– the gains from exchange, and
– the gains from specialization.
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.
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.
Exporting Country
Price
of Steel
Price
after
trade
Domestic
supply
Exports
A
B
Price
before
trade
World
price
D
D = gains from trade
C
Domestic
demand
0
Quantity
of Steel
Gains From Exchange
Price
of Steel
Domestic
Supply
Exports
Price
after
trade
A
B
Price
before
trade
D = gains from exchange
World
price
D
C
Domestic
demand
0
Quantity
of Steel
D = gains from exchange; E = gains from
specialization; D + E = total gains from trade
Price
of Steel
Price
after
trade
Domestic
supply
Exports
A
B
Price
before
trade
D
World
price
E
C
Domestic
demand
0
Quantity
of Steel
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
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
Common Arguments For Restricting Trade
•
•
•
•
•
Jobs
National Security
Infant Industry
Unfair Competition
Protection-as-a-Bargaining Chip