Florence harbor

Module 1

International
Trade Theory
Part I INTERNATIONAL TRADE THEORY

Module 1 Trade Theories

The nation adopted to freer trade regime.

How do the prices move?
What will be the quality / variety of product available to the consumers?
Which businesses are likely to survive or grow?

• Issues of pricing under differing degrees of international competitiveness

• Understanding free trade arguments that govern trade agreements.
 Trade Patters, prices and
1 gains from trade
Consider the following change in environment:

• Nations progressively adopt a liberal trade regime as members of the

World Trade Organisation / or any other free trade agreement.

• Government controls are withdrawn from export and import of

commodities.

How does this impact prices of traded commodities?

Is it gainful? If so, to whom?
Essential change that accompany free trade

Increased Competition in product and factor market

Changes the way choices are made by firms.

In a protected environment
Technology / efficiency given→ cost → price

In a competitive environment
Firm is a Price taker → firms maximise prifit (= revenue - cost of production)
→ adopt the technology that gives the minimum cost, sell competitive
quantities
• 2 countries – Home and Foreign
• One product considered – say, Furnishing Textile of a given quality
• Markets are competitive – all producers charge identical prices
• In closed market each country’s market is separated from another country.
• Home price in closed market = 2000 > Foreign price in closed market = 1000
• Ignore the transport costs for now.

If trade is allowed – which country will export?

 Home country : closed market of Furnishing Textiles.

2000

600 Q
 Home country : closed market of Furnishing Textiles.

P a = consumers’ surplus
b = produces’ surplus
a
2000
b

600 Q
 Import demand of furnishings from HOME country

P P

2000 2000

600 Q Q

Home Demand: Q(HD)= A - BP Demand for imports :

Home Supply: Q (HS) = C + DP Q(DM) = Q(HD) – Q(HS)
 Foreign country : closed market of Furnishing Textiles.

1000

400 Q
 Foreign country : closed market of Furnishing Textiles.

A = consumers’ surplus
B = produces’ surplus

1000
B

400 Q
 Export supply of furnishings from FOREIGN country

P P

1000
1000

400 Q Q
Foreign Demand: Q(FD)= G - KP Supply of exports :
Foreign Supply: Q (FS) = M + NP Q(SE) = Q(FS)– Q(FD)
 Determining
Free trade world price

2000 2000 2000

1600 1600 1600

1000 1000 1000

300 800 Qw 200 700

Home World Foreign

 Determining
Free trade world price

2000 2000

1600 1600

1000 1000

300 800 200 700

Home Foreign
 Determining
Free trade world price
Welfare gain for Home = c Welfare gain for Foreign = C

2000 2000

c
1600 1600
C
1000 1000

300 800 200 700

Home Foreign

It is due to this gain to consumers in the importing country and to exporters in the exporting country
that trade is thought of as gainful and hence liberalised.
Note that there are some losers of trade too.
Note:
1000 1600 2000

Exporting Free trade price Importing

country closed country closed
border price border price

We worked under the following assumption:

1. There is one commodity that a country trades.

2. Markets are competitive
3. Transport costs are negligible

Altering assumptions may alter outcomes.

Reading

From reading material on module 1-

“The Basic Theory using Demand and Supply”