Central Luzon State University

COLLEGE OF BUSINESS ADMINISTRATION AND ACCOUNTANCY

Science City of Munoz, Nueva Ecija

DEPARTMENT OF BUSINESS ADMINISTRATION

Economics Section

Econ 4114
International Economics

2ModModule 2ule 2
Module 2: le
The Basic Theory UsingDemand and Supply

For centuries people have been fighting over whether

governments should allow trade between countries. There have been, and probably
always will be, two sides to the argument. Some argue that just letting everybody trade
freely is best for both the country and the world. Others argue that trade with other
countries makes it harder for some people to make a good living. Both sides are at least
partly right.
International trade matters a lot. Its effects on the economic life of people
in a country are enormous. Imagine a world in which the Philippines did not trade at all with
other countries. It isn’t hard to do. Imagine what kind of job you would be likely to get, and
think of what products you could buy (or not buy) in such a world. In each case there are
people who gain and people who lose from cutting off international trade. Every one of these
differences between less trade and more trade has strong effects on what career you choose.
Little wonder, then, that people are always debating the issue of having less or more trade.
Each side of the trade debate needs a convincing story of just how trade
matters and to whom. Yet that story, so useful in the arena of policy debate, requires an even
more basic understanding of why people trade as they do when allowed to trade, exporting
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some products and importing others. If we do not know how people decide what goods and
services to trade, it is hard to say what the effects of trade are or whether trade should be
restricted by governments.

FOUR QUESTIONS ABOUT TRADE

This module tackles the issue of how trade works by comparing two
worlds. In one world no trade is allowed. In the other, governments just stand aside and
let individual businesses and households trade freely across national borders. We seek
answers to four key questions:
1. Why do countries trade? More precisely, what determines which products
a country exports and which products it imports?
2. How does trade affect production and consumption in each country?
3. How does trade affect the economic well-being of each country? In what
sense canwe say that a country gains or loses from trade?
4. How does trade affect the distribution of economic well-being or income
among various groups within the country? Can we identify specific groups that gain
from trade and other groups that lose because of trade?
Our basic theory of trade says that trade usually results from the
interaction of com-petitive demand and supply. This module goes to the basic picture of
demand and supply. It suggests answers to the four questions about trade, including how
to measure the gains that trade brings to some people and the losses it brings to others.
We are embarking on an extended exploration of international trade.
The first box in this chapter, “Trade Is Important,” provides information that sets the stage
for our journey. The chapter’s second box, “The Trade Mini-Collapse of 2009,” shows how
trade declined much more than general economic activity during the global financial and
economic crisis.

DEMAND AND SUPPLY

Let’s review the economics of demand and supply before we apply

these tools to examine international trade. The product that we use as an example is
motorbikes. We assume that the market for motorbikes is competitive. Although the
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analysis appears to be only about a single product (here, motorbikes), it actually is
broader than this. Demanders make decisions about buying this product instead of other
products. Sup- pliers use resources to produce this product, and the resources used in
producing motorbikes are not available to produce other products. What we are studying
is actu-ally one product relative to all other goods and services in the economy.
Demand
What determines how much of a product is demanded? A consumer’s
problem is to get as much happiness or well-being (in economists’ jargon, utility) as
possible by spend- ing the limited income that the consumer has available. A basic
determinant of how much a consumer buys of a product is the person’s taste,
preferences, or opinions of the product. Given the person’s tastes, the price of the product
(relative to the prices of other products) also has a major influence on how much of the
product is purchased. At a higher price for this product, the consumer usually economizes
and reduces the quantity purchased. Another major influence is the consumer’s income. If
the consumer’s income increases, the consumer buys more of many products, probably
including more of this

IGURE 2.1
DPrice Price

F
Figure 2.1
Demand and
Supply for
Motorbikes

The market demand curve for motorbikes slopes downward. A lower price results
in a larger quantity demanded. The market supply curve for motorbikes slopes upward. A higher price
results in a larger quantity supplied.
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product. (The consumer buys more if this product is a normal good. This is not the only
possibility—quantity purchased is unchanged if demand is independent of income, and quantity
goes down if the product is an inferior good. In this text we almost always examine only
normal goods, as we consider these to be the usual case.)
How much the consumer demands of the product thus depends on a
number of influences: tastes, the price of this product, the prices of other products, and
income. We would like to be able to picture demand. We do this by focusing on one major
determinant, the product’s price. After we add up all consumers of the product, we use a
market demand curve like the demand curve for motorbikes shown as D in Figure 2.lA.1 We
have a strong presumption that the demand curve slopes downward. An increase in the
product’s price (say, from $1,000 per motorbike to $2,000) results in a decrease in quantity
demanded (from 65,000 to 40,000 motorbikes purchased per year). This is a movement along
the demand curve because of a change in the product’sprice. The increase in price results in a
lower quantity demanded as people (somewhat reluctantly) switch to substitute products (e.g.,
bicycles) or make do with less of the more expensive product (forgo buying a second
motorbike of a different color).
How responsive is quantity demanded to a change in price? One way to
measure responsiveness is by the slope of the demand curve (actually, by the inverse of the slope
because price is on the vertical axis). A steep slope indicates low responsiveness of quantity to a
change in price (quantity does not change that much). A flatter slope indicates more
responsiveness. The slope is a measure of responsiveness, but it can also be misleading. By
altering the units used on the axes, the demand curve can be made to look flat or steep.
A measure of responsiveness that is “unit-free” is elasticity, the percent
change in one variable resulting from a 1 percent change in another variable. The price
elasticity of demand is the percent change in quantity demanded resulting from a
1 percent increase in price. Quantity falls when price increases (if the demand curve
slopes downward), so the price elasticity of demand is a negative number (though we
often drop the negative when we talk about it). If the price elasticity is a large (nega-
tive) number (greater than 1), then quantity demanded is substantially responsive to a
price change—demand is elastic. If the price elasticity is a small (negative) number (less
than 1), then quantity demanded is not that responsive—demand is inelastic.
In drawing the demand curve, we assume that other things that can
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influence demand—income, other prices, and tastes—are constant. If any of the other
influences changes, then the entire demand curve shifts.

Consumer Surplus
The demand curve shows the value that consumers place on units of
the product because it indicates the highest price that some consumer is willing to pay
for each unit. Yet, in a competitive market, consumers pay only the going market price
for these units. Consumers who are willing to pay more benefit from buying at the market
price. Their well-being is increased, and we can measure how much it increases.
To see this, consider first the value that consumers place on the total
quantity of the product that they actually purchase. We can measure the value unit by
unit. For the first motorbike demanded, the demand curve in Figure 2.1A tells us that
somebody would be willing to pay a very high price (about $3,600)—the price just
below where the demand curve hits the price axis. The demand curve tells us that
somebody is will-ing to pay a slightly lower price for the second motorbike, and so on
down the demand curve for each additional unit.
By adding up all of the demand curve heights for each unit that is
demanded, we see that the whole area under the demand curve (up to the total
consumption quantity) measures the total value to consumers from buying this quantity
of motorbikes. For instance, for 40,000 motorbikes the total value to consumers is $112
million, equal to area c 1 t 1 u. This amount can be calculated as the sum of two areas
that are easier to work with: the area of the rectangle t 1 u formed by price and
quantity, equal to $2,000 3 40,000, plus the area of triangle c above this rectangle,
equal to (1/2) 3 ($3,600 2 $2,000) 3 40,000. (Recall that the area of a triangle like
c is equal to one-half of the product of its height and base.) This total value can be
measured as a money amount, but it ultimately represents the willingness of consumers,
if necessary, to forgo consuming other goods and services to buy this product.
The marketplace does not give away motorbikes for free, of course.
The buyers must pay the market price (a money amount, but ultimately the value of
other goods and services that the buyers must give up to buy this product). For instance,
at a price of $2,000 per motorbike, consumers buy 40,000 motorbikes and pay $80
million in total (price times quantity, equal to area t 1 u).
Because many consumers value the product more highly than $2,000

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per motor- bike, paying the going market price still leaves consumers with a net gain in
economic well-being. The net gain is the difference between the value that consumers
place on the product and the payment that they must make to buy the product. This
net gain is called consumer surplus, the increase in the economic well-being of
consum-ers who are able to buy the product at a market price lower than the highest
price that they are willing and able to pay for the product. For a market price of $2,000
in SFigure 2.1A, the consumer surplus is the difference between the total value to
consum- ers (area c 1 t 1 u) and the total payments to buy the product (area t 1 u).
Consumer surplus thus is equal to area c, the area below the demand curve and above
the price line. This contribution to the economic well-being of consumers through the
use of this market is $32 million, equal to (1/2) 3 ($3,600 2 $2,000) 3 40,000.
A major use of consumer surplus is to measure the impact on consumers of
a change in market price. For instance, what is the effect in our example if the market price of
motor-bikes is $1,000 instead of $2,000? Consumers are better off—they pay a lower price and
decide to buy more. How much better off? Consumer surplus increases from a smallertriangle
(extending down to the $2,000 price line) to a larger triangle (extending down to the $1,000
price line). The increase in consumer surplus is area t 1 d. This increase can be calculated as
the area of rectangle t, equal to ($2,000 2 $1,000) 3 40,000, plusthe area of triangle d, equal
to (1/2) 3 ($2,000 2 $1,000) 3 (65,000 2 40,000). The increase in consumer surplus is $52.5
million. The lower market price results in both an increase in economic well-being for
consumers who would have bought anyway at the higher price (area t) and an increase in
economic well-being for those consumers who are drawn into purchasing by the lower price
(area d).
Supply
What determines how much of a product is supplied by a business
firm (or other pro-ducer) into a market? A firm supplies the product because it is trying
to earn a profit on its production and sales activities. One influence on how much a firm
supplies is the price that the firm receives for its sales. The other major influence is the
cost of producing and selling the product.
For a competitive firm, if the price at which the firm can sell another unit
of its product exceeds the extra (or marginal) cost of producing it, then the firm should supply
that unit because it makes a profit on it. The firm then will supply units up to the point at
which the price received just about equals the extra cost of another unit. The cost of producing
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another unit depends on two things: the resources or inputs (such as labor, capital, land, and
materials) needed to produce the extra unit and the prices that have to be paid for these inputs.
We would like to be able to picture supply, and we do so by focusing on how
the price of the product affects quantity supplied. After we add up all producers of the product,
we use a market supply curve like the supply curve S for motorbikes in Figure 2.1B.2 We
usually presume that the supply curve slopes upward. An increase in the product’s price (say,
from $1,000 per motorbike to $2,000) results in an increase in quantity supplied (from 15,000
to 40,000 motorbikes produced and sold per year). This is a movement along the supply curve.
In a competitive industry, an additional motorbike is supplied if the price received covers the
extra cost of producing and selling this additional unit. If additional units can be produced only
at a rising extra or marginal cost, then a higher price is necessary to draw out additional quantity
supplied. The supply curve turns out to be the same as the curve showing the marginal cost of
producing each unit.
How responsive is quantity supplied to a change in the market price?
One way to measure responsiveness is by the slope of the supply curve. Quantity supplied
is more responsive if the slope is flatter. A “unit-free” measure is the price elasticity of
supply—the percent increase in quantity supplied resulting from a 1 percent increase in
market price. Quantity supplied is not that responsive to price—supplyis inelastic—if the
price elasticity is less than 1. Quantity supplied is substantially responsive—supply is
elastic—if the price elasticity is greater than 1.
In drawing the supply curve, we assume that other things influencing
supply are constant. These other things include the conditions of availability of inputs and the
technology that determines what inputs are needed to produce extra units of the product. If
any of these other influences changes, then the entire supply curve shifts.
Producer Surplus
The supply curve shows the lowest possible price at which some
producer would be willing to supply each unit. Producers actually receive the going market
price for these units. Producers who would have been willing to supply at a lower price benefit
from selling at the market price. Indeed, we can measure how much their well-being increases.
To see this, consider first the total (variable) costs of producing and selling
the total quantity that is actually supplied. We can measure this cost unit by unit. For the first
motorbike supplied into the market, the supply curve in Figure 2.1B tells us that some producer
would be willing to supply this for about $400, the price just above where the supply curve
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hits the axis. This amount just covers the extra cost of producing and selling this first unit. The
supply curve tells us that some producer is willing to supplythe second motorbike for a slightly
higher price because the extra cost of the second unit is a little higher, and so on.
By adding up all of the supply curve heights for each unit supplied, we
find that the whole area under the supply curve (up to the total quantity supplied) is the total
cost of producing and selling this quantity of motorbikes. For instance, the total cost of
producing 15,000 motorbikes is equal to area z in Figure 2.1B. This total cost can be measured
as a money amount, but for the whole economy it ultimately represents an opportunity
cost—the value of other goods and services that are not produced because resources are
instead used to produce this product (motorbikes).
The total revenue received by producers is the product of the market price
and the quantity sold. For instance, at a price of $1,000 per motorbike, producers sell 15,000
motorbikes, so they receive $15 million in total revenue (equal to area e + z).
Because producers would have been willing to supply some motorbikes
at a price below $1,000, receiving the going market price for all units results in a net gain
in their economic well-being. The net gain is the difference between the rev- enues received
and the costs incurred. This net gain is called producer surplus, the increase in the
economic well-being of producers who are able to sell the product at a market price higher
than the lowest price that would have drawn out their supply. For a market price of $1,000
in Figure 2.1B, the producer surplusis the difference between total revenues (area e + z)
and total costs (area z). Producer surplus is thus equal to area e, the area above the supply
curve and below the price line. Producer surplus in this case is $4.5 million, equal to (1/2) 3
($1,000 2 $400) 3 15,000.
A major use of producer surplus is to measure the impact on
producers of a change in market price. For instance, what is the effect if the market
price is $2,000 instead of $1,000? Producers are better off—they receive a higher price
and decide to produce and sell more. Producer surplus increases from a smaller triangle
(extending up to the $1,000 price line) to a larger triangle (extending up to the $2,000
price line). The increase in producer surplus is equal to area w + v,

8
or ($2,000 2 $1,000) 3 15,000 plus (l/2) 3 ($2,000 2 $1,000) 3 (40,000 15,000),
which equals $27.5 million. The higher market price results in both an increase in economic
well-being for producers who would have supplied anywayat the lower price (area w) and
an increase in well-being for producers of the addi- tional units supplied (area v).

A National Market with No Trade

If D in Figure 2.1A represents the national demand for the product and S in Figure
2.1B represents the national supply, we can combine these into the single picture for the
national market for this product, as shown in Figure 2.2. If there is no international trade,
then equilibrium occurs at the price at which the market clears domestically, with national
quantity demanded equal to national quantity supplied. In Figure 2.2 this no-trade
equilibrium occurs at point A, with a price of $2,000 per motorbike and total quantity
supplied and demanded of 40,000 motorbikes. Both consumers and produc- ers benefit
from having this market, as consumer surplus is area c and producer sur- plus is area h
(the same as area e + w + v in Figure 2.1B). In this example, both gain the same amount
of surplus, $32 million each. In general, these two areas do not have to be equal, though
both will be positive amounts. For instance, consumer surplus will be larger than producer

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 surplus if the demand curve is steeper (more inelastic) or the supply curve is flatter (more
elastic) than those shown in Figure 2.2.

TWO NATIONAL MARKETS AND THE OPENING OF TRADE

To discuss international trade in motorbikes, we need at least two

countries. We will call the country whose national market is shown in Figure 2.2 the United
States. This U.S. national market is also shown in the left-hand graph of Figure 2.3; we
add the subscript US to make this clear. We will call the other country the “rest of the world.”
The “national” market for the rest of the world is shown in the right-hand graph of Figure
2.3. Demand for motorbikes within the rest of the world is Df , and supply is Sf . With no
trade, the market equilibrium in the rest of the world occurs at point H, with a price of $700
per motorbike. To focus on the basic aspects of the situation, we will assume that prices in
the two countries are stated in the same monetary units.
In the international market for motorbikes, the desire to trade is the
(horizontal) difference between national demand and supply. The difference between U.S.
demand and supply, on the left, is graphed in the center diagram as the U.S. demand for
imports (the Dm curve). The difference between foreign supply and demand, on the right, is
graphed in the center diagram as the foreign supply of exports (the Sx curve). The
interactions of demand and supply in both countries determine the world price of motorbikes
and the quantities produced, traded, and consumed.

Starting from this initial situation of no trade in motorbikes between the two
coun- tries, can an observant person profit by initiating some trade? Using the
principle of “buy low, sell high,” the person could profit by buying motorbikes for
$700 per motor- bike in the rest of the world and selling them for $2,000 per
motorbike in the United States, earning profit (before any other expenses) of $1,300
per motorbike. This is called arbitrage—buying something in one market and
reselling the same thing in another market to profit from a price difference.

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11
 Free-Trade Equilibrium
As international trade in motorbikes develops between these
two countries, it affects market prices in the countries:
• The additional supply into the United States, created by
imports, reduces the mar- ket price in the United States.
• The additional demand met by exports increases the market
price in the rest of the world.
In fact, if there are no transport costs or other frictions, free
trade results in the two countries having the same price for motorbikes. We will
call this free-trade equilib- rium price the international price or world price.
What will this free-trade equilibrium price be? We can
picture the price by con- structing the market for international trade in
motorbikes. The U.S. demand for imports can be determined for each
possible price at which the United States might import. This demand for imports
is the excess demand (quantity demanded minus quantity supplied) for
motorbikes within the U.S. national market. For instance, at a price of $2,000 per
motorbike, the U.S. national market clears by itself, and there is no excess demand
and no demand for imports. If the price in the U.S. market is $1,000 per
motorbike, then there is excess demand of distance CB, equal to 50,000 units,
creating a demand for imports of 50,000 motorbikes at this price. If excess
demands at other prices below $2,000 per motorbike are measured, the curve
Dm, representing
U.S. demand for imports, can be drawn, as shown in the
middle graph of Figure 2.3.
The export supply from the rest of the world can be
determined in a similar way. The supply of exports is the excess supply
(quantity supplied minus quantity demanded) of motorbikes in the rest-of-the-
world market. For instance, at a price of
$700 per unit, this market clears by itself, and there is no
excess supply and no export supply. If the price in this market is $1,000 per
motorbike, then excess supply is dis- tance IJ equal to 50,000 units, creating a
supply of exports of 50,000 motorbikes at this price. If excess supplies for other
prices above $700 per motorbike are measured, the curve Sx, representing export
supply from the rest of the world, can be drawn, as shown in the middle graph
of Figure 2.3.
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 Free-trade equilibrium occurs at the price that clears the international
market. In Figure 2.3 this is at point E, where quantity demanded of imports equals quantity
sup- plied of exports. The volume of trade (FE) is 50,000 motorbikes and the free-trade
equilibrium price is $1,000 per motorbike.
This equilibrium can also be viewed as equating total world demand
and supply. The international price is the price in each national market with free trade. At
the price of $1,000 per motorbike, total world quantity demanded is 90,000 units (65,000 in
the United States and 25,000 in the rest of the world), and total world quantity supplied is
also 90,000 units (15,000 plus 75,000). The excess demand within the U.S. market (CB) of
50,000 motorbikes is met by the excess supply from the rest-of-the-world market (IJ ). What
would happen if the world price for some reason was (temporarily) different from $1,000
per motorbike? At a slightly higher price (say, $1,100 per motorbike):
• The U.S. excess (or import) demand would be less than 50,000 motorbikes.
• The rest of the world’s excess (or export) supply would be above 50,000
units.

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 Because export quantity supplied exceeds import quantity demanded, the
imbalance creates pressure for the price to fall back to the equilibrium value of $1,000 per
motor- bike. Conversely, a price below $1,000 would not last because U.S. import quantity
demanded would be greater than the foreign export quantity supplied.
Effects in the Importing Country
Opening trade in motorbikes has effects on economic well-being (in
economists’ jargon, welfare) in both the United States and the rest of the world. We will first
examine changes in the importing country, the United States. Figure 2.4 reproduces Figure
2.3 and adds labels for the areas relevant to consumer and producer surplus.
Effects on Consumers and Producers
For the United States (the importing country), the shift from no trade to
free trade lowers the market price. U.S. consumers of the product benefit from this change
and increase their quantity consumed. The concept of consumer surplus allows us

FIGURE 2.4 The Effects of Trade on Well-Being of Producers,

Consumers, and the Nation as a Whole

A. The U.S. B. International C. The Rest of the World’s

Motorbike Market Motorbike Market
Price Price Price

2,000 2,000
U.S. pretrade
price

Exports Sf
F
1,000 1,000 1,000
j I k

(thousands)

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 Welfare Effects of Free Trade

to quantify what the lower price is worth to consumers. With free

trade, consumer surplus is the area below the demand curve and above the international
price line of $1,000 per motorbike, equal to area a 1 b 1 c 1 d (the same as area t
1 c 1 d in Figure 2.1A). Thus, in comparison with the no-trade consumer surplus of
area c, the opening of trade brings consumers of this product a gain of area a 1 b 1 d
(equal to $52.5 million, area t 1 d in Figure 2.1A). This gain is spread over many people
who consume this product (including some who are also producers of the product).
U.S. producers of this product (in their role as producers) are hurt by
the shift from no trade to free trade. They receive a lower price for their product and
shrink produc- tion. Producer surplus decreases from area e 1 a with no trade (the
same as area e 1 w 1 v in Figure 2.1B) to only area e. The loss in producer surplus is
area a (equal to $27.5 million). Area a is a loss of producer surplus both on the 15,000
motorbikes still produced in the United States and on the 25,000 that are no longer
produced in the United States as imports capture this part of the market.3

Net National Gains

If U.S. consumers gain area a 1 b 1 d from the opening of trade and
U.S. producers lose area a, what can we say about the net effect of trade on the United
States? There is no escaping the basic point that we cannot compare the welfare effects
on differ- ent groups without imposing our subjective weights to the economic stakes of
each group. Our analysis allows us to quantify the separate effects on different groups,
but it does not tell us how important each group is to us. In our example, how much
of the consumer gain does the producer loss of $27.5 million offset in our minds? No
theorem or observation of economic behavior can tell us. The result depends on our
15
value judgments.
Economists have tended to resolve the matter by imposing the value
judgment that we call the one-dollar, one-vote metric—each dollar of gain or
loss is valued equally, regardless of who experiences it. The metric implies a
willingness to judge trade issues on the basis of their effects on aggregate well-being,
without regard to their effects on the distribution of well-being. This does not signify
a lack of interest in the issue of distribution. It only means that one considers the
distribution of well-beingto be a matter better handled by compensating those hurt by
a change or by using some other direct means of redistributing well-being toward
those groups (for example, the poor) whose dollars of well-being seem to matter more
to us.
You need not accept this value judgment. You may feel that the stake of,
say, motorbike producers matters much more to you, dollar for dollar, than the stake of
motorbike consumers. You might feel this way, for example, if you knew that the pro- ducers
are poor, unskilled laborers, whereas the consumers are rich. And you might also feel that
there is no politically feasible way to compensate the poor workers for their income losses
from the opening of trade. If so, you may wish to say that each dollar lost by producers means
five or six times as much to you as each dollar gained by consumers. Taking this stand leads
you to conclude that opening trade violates your conception of the national interest. Even in
this case, however, you could still find the demand2supply analysis useful. It is a way of
quantifying the separate stakes of groups whose interests you weight unequally.
If the one-dollar, one-vote metric is accepted, then the net national
gains from trade equal the difference between what one group gains and what the other
group loses. If motorbike consumers gain area a 1 b 1 d and motorbike producers lose area a,
the net national gain from trade is area b 1 d, or a triangular area worth $25 million per year
[5 (1/2) 3 (65,000 2 15,000 motorbikes) 3 ($2,000 2 $1,000) per motor- bike]. It turns out
that very little information is needed to measure the net national gain. All that is needed is
an estimate of the amount of trade and an estimate of the change in price brought about by
trade.

Effects in the Exporting Country

For the rest of the world (the exporting country), the analysis follows a
similar path. Here the shift from no trade to free trade increases the market price. The increase
in price benefits motorbike producers in the rest of the world, whose producer surplus increases
by area j 1 k 1 n in Figure 2.4. The increase in price hurts motorbike consumers, whose
consumer surplus decreases by area j 1 k. In the exporting country, producers of the product
16
gain and consumers lose. Using the one-dollar, one-vote metric, we can say that the rest of the
world gains from trade, and that its net gain from trade equals area n.

Which Country Gains More?

This analysis shows that each country gains from international trade, so it
is clear that the whole world gains from trade. Trade is a positive-sum activity. At the same
time, the gains to the countries generally are not equal—area b 1 d is generally not equal to
area n. These two triangles can be compared rather easily. They both have the same base (equal
to 50,000 units, the volume of trade). The height of each triangle is the change in price in the
shift from no trade to free trade for each country. Thus, the country that experiences the larger
price change has a larger value of the net gains from trade.
The gains from opening trade are divided in direct proportion to the price
changes that trade brings to the two sides. If a nation’s price changes x percent (as a
percentage of the free-trade price) and the price in the rest of the world changes y percent,
then
Nation’s gain = x
Rest of world’s gain y

17
 The side with the less elastic (steeper) trade curve (import demand curve
or export supply curve) gains more.
In Figure 2.4, the United States gains more. Its gains from trade in this
product are $25 million. Its price changes from $2,000 to $1,000, equal to 100 percent
of the free-trade price $1,000. The gains from trade for the rest of the world are
$7.5 million. Its price changes from $700 to $1,000, equal to 30 percent
of the free-trade price.

Extending the familiar demand-supply

framework to international trade has given us useful preliminary
answers to the four basic questions about international trade. The
contrast between no trade and free trade offers these conclusions:
1. Why do countries trade? Demand and supply
conditions differ between countries, so prices differ between
countries if there is no international trade. Trade begins as someone
conducts arbitrage to earn profits from the price difference between
previously separated markets. A product will be exported from
coun-tries where its price was lower without trade to countries where
its price was higher.
2. How does trade affect production and
consumption in each country? The move from no trade to a free-trade
equilibrium changes the product price from its no- trade value to the
free-trade equilibrium international price or world price. The
price change in each country results in changes in quantities
consumed and produced. In the country importing the product, trade
raises the quantity consumed and lowers the quantity produced of that
product. In the exporting country, trade raises the quantity produced
and lowers the quantity consumed of the product.
3. Which country gains from trade? If we use the
one-dollar, one-vote metric, then both do. Each country’s net
national gains from trade are proportional to the change in its
price that occurs in the shift from no trade to free trade. The country
18
w whose prices are disrupted more by trade gains more.
h 4. Within each country, who are the gainers and
o losers from opening trade? The gainers are the consumers of imported
s products and the producers of exportable products. Those who lose
e are the producers of import-competing products and the consumers of
p exportable products.
r

Reference: Pugel, Thomas A.. (2016). International Economics (Ed.

16). America: McGraw-Hill

Compiled by:

Judith A. Teano, PhD/EnP

Associate Professor V
Economics Section
CBAA, CLSU
jteano@clsu.edu.ph
09173111171

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