Friday

 

Free Trade Maximizes Total Surplus And Total Wealth

Mostly summarized from sections of Gregory Mankiw’s Principles of Economics, 5th Ed., Chapter 9.

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Figure 1 - Equilibrium without International Trade

This figure for hypothetical country “Isoland” shows consumer and producer surplus in equilibrium without international trade for the textile market.

When an economy does not trade in world markets the price and quantity adjusts to balance only the domestic supply and demand.

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Figure 2 –International Trade in an Exporting Country

Once Isoland engages in international trade the originally lower domestic price before trade rises to equal the after-trade higher world price.

This is because the added demand in other countries drives up the price.

The domestic supply curve shows the quantity of textiles produced domestically.

The domestic demand curve shows the quantity of textiles consumed domestically.

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The higher world price of textiles now applies to Isoland.

Textiles exports quantity from Isoland equals the difference between:

· the domestic quantity supplied, the quantity produced in Isoland, now a greater amount because of the higher world price for textiles

- and -

· the domestic quantity demanded, the quantity consumed in Isoland, now a smaller amount because of the new higher price for textiles, resulting from added world demand

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Isoland producers of textiles are now better off because producer surplus rises from C to C+B+D1.

Isoland consumers are now worse off because consumer surplus falls from A+B to A.

Total surplus rises by an amount equal to area D1.

The addition of area D1 shows trade, more exports, raises the economic well-being of the country as a whole.

Isoland textile consumers are worse off by losing area B but Isoland textile producers are much better off by gaining B+D1.

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Isoland is a small economy compared to the rest of the world.

Once Isoland participates in international trade, its consuming and supplying actions have no or little effect on world markets quantities and prices.

Any changes in Isoland's trade policy will not affect world price of textiles.

Isolanders are price takers in the world economy as they must take the textiles world price as given.

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The horizontal line world price

· represents the rest of the world's price for textiles

· can also be labeled world demand

Because Isoland is a small country, this world price demand curve facing its domestic textile suppliers is perfectly elastic, is horizontal.

When a country allows trade and becomes an exporter of a good

· domestic producers of the good are better off

· domestic consumers of the good are worse off

But trade raises the overall economic well-being of a nation because the gains of the winners exceed the losses of the losers.

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Figure 3 – International Trade in an Importing Country

Now Isoland engages in international trade, the originally higher domestic price for widgets before trade falls to equal the after-trade world price.

This is because added supply drives down the price.

The domestic supply curve shows the amount of widgets produced domestically.

The domestic demand curve shows the amount consumed domestically.

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The lower world price of widgets now applies to Isoland.

Imports quantity into Isoland equals the difference between:

· the domestic quantity supplied, the quantity produced in Isoland, now a smaller amount because of the lower world price for widgets

- and -

· the domestic quantity demanded, the quantity consumed in Isoland, now a larger amount because of the new lower world price for widgets, resulting from added world supply

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Isoland producers of widgets are worse off because producer surplus falls from B+C to C.

Isoland consumers of widgets are better off because consumer surplus rises from A to A+B+D2.

Total surplus rises by an amount equal to area D2.

The addition of area D2 shows trade, more imports, raises the economic well-being of the country as a whole.

Isoland producers are worse off by losing area B but Isoland consumers are much better off by gaining B+D2.

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The horizontal line world price represents the rest of the world's price for widgets and can also be labeled world supply.

Because Isoland is a small country, this world price supply curve facing its consumers is perfectly elastic, is horizontal.

When a country allows trade and becomes an importer of a good:

· domestic producers of the good are worse off

· domestic consumers of the good are better off

Again here with imports as with exports, trade raises the economic well-being of a nation because the gains of the winners exceed the losses of the losers.

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Overall, after engaging in free international trade Isoland is now much better off, by sum of Figure 2 area D1 and Figure 3 area D2.

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In either case of exporting textiles or importing widgets, the gains of the winners exceed the losses of the losers.

Opening an economy to international trade is a policy that expands the overall size of the economy.

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Because trade creates winners and losers, debate over trade policy usually is contentious.

Nations restrict trade because the losers from free trade, most often current domestic suppliers including their employees:

· are better organized and focused than the consumer winners

· turn their organization and focus into political clout

· lobby for trade restrictions such as tariffs or import quotas

The United States would have a significantly smaller economy and lower GDP and incomes per person if each state was instead a country with restrictions on trade and movement of assets including people.

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If all the individual states of the United States charged a 10% duty on products imported from all other states how much lower would the total U.S. GDP be?

Gemini:

Economic theory and current trade data suggest the impact would be huge, likely reducing the total U.S. GDP by at least 15% to 25%—roughly $4 trillion to $7 trillion in today's economy.