Macro Chapter 4 Handouts

I. The Determinants of Trade

A. Example used throughout the chapter: The market for textiles in a country
called Isoland.

B. The Equilibrium without Trade

1. If there is no trade, the domestic price in the textile market will balance
supply and demand.
Figure 1

2. A new leader is elected who is interested in pursuing trade. A

committee of economists is organized to determine the following:

a. If the government allows trade, what will happen to the price of

textiles and the quantity of textiles sold in the domestic market?

b. Who will gain from trade, who will lose, and will the gains exceed
the losses?

c. Should a tariff (a tax on imported textiles) be part of the new trade

policy?

C. The World Price and Comparative Advantage

1. The first issue is to decide whether Isoland should import or export

textiles.

a. The answer depends on the relative price of textiles in Isoland

compared with the price of textiles in other countries.
 b. Definition of world price: the price of a good that prevails in
the world market for that good.

2. If the world price is greater than the domestic price, Isoland should
export textiles; if the world price is lower than the domestic price,
Isoland should import textiles.

a. Note that the domestic price represents the opportunity cost of

producing textiles in Isoland, while the world price represents the
opportunity cost of producing textiles abroad.

b. Thus, if the domestic price is low, this implies that the opportunity
cost of producing textiles in Isoland is low, suggesting that Isoland
has a comparative advantage in the production of textiles. If the
domestic price is high, the opposite is true.

II. The Winners and Losers from Trade

A. We can use welfare analysis to determine who will gain and who will lose if
free trade begins in Isoland.
B. We will assume that, because Isoland would be such a small part of the
market for textiles, they will be price takers in the world economy. This
implies that they take the world price as given and must sell (or buy) at
that price.

C. The Gains and Losses of an Exporting Country

1. If the world price is higher than the domestic price, Isoland will export
textiles. Once free trade begins, the domestic price will rise to the
world price.

2. As the price of textiles rises, the domestic quantity of textiles

demanded will fall and the domestic quantity of textiles supplied will
rise. Thus, with trade, the domestic quantity demanded will not be
equal to the domestic quantity supplied.

Figure 2
3. Welfare without Trade

a. Consumer surplus is equal to: A + B.

b. Producer surplus is equal to: C.

c. Total surplus is equal to: A + B + C.

4. Welfare with Trade

a. Consumer surplus is equal to: A.

b. Producer Surplus is equal to: B + C + D.

c. Total surplus is equal to: A + B + C + D.

5. Changes in Welfare

a. Consumer surplus changes by: –B.

 b. Producer surplus changes by: +B + D.

c. Total surplus changes by: +D.

6. When a country exports a good, domestic producers of the good are

better off and domestic consumers of the good are worse off.

7. When a country exports a good, total surplus is increased and the

economic well-being of the country rises.

D. The Gains and Losses of an Importing Country

1. If the world price is lower than the domestic price, Isoland will import
textiles. Once free trade begins, the domestic price will fall to the world
price.

2. As the price of textiles falls, the domestic quantity of textiles

demanded will rise and the domestic quantity of textiles supplied will
fall.

a. Thus, with trade, the domestic quantity demanded will not be equal
to the domestic quantity supplied.

b. Isoland will import the difference between the domestic quantity

demanded and the domestic quantity supplied.

Figure 3
 3. Welfare without Trade

a. Consumer surplus is equal to: A.

b. Producer surplus is equal to: B + C.

c. Total surplus is equal to: A + B + C.

4. Welfare with Trade

a. Consumer surplus is equal to: A + B + D.

b. Producer surplus is equal to: C.

c. Total surplus is equal to: A + B + C + D.

5. Changes in Welfare

a. Consumer surplus changes by: +B + D.

b. Producer surplus changes by: –B.

c. Total surplus changes by: +D.

6. When a country imports a good, domestic consumers of the good are

better off and domestic producers of the good are worse off.

7. When a country imports a good, total surplus is increased and the

economic well-being of the country rises.

E. Trade policy is often contentious because the policy creates winners and
losers. If the losers have political clout, the result is often trade restrictions
such as tariffs and quotas.
F. The Effects of a Tariff

1. Definition of tariff: a tax on goods produced abroad and sold

domestically.

2. A tariff raises the price above the world price. Thus, the domestic price
of textiles will rise to the world price plus the tariff.

3. As the price rises, the domestic quantity of textiles demanded will fall
and the domestic quantity of textiles supplied will rise. The quantity of
imports will fall and the market will move closer to the domestic
market equilibrium that occurred before trade.

4. Welfare before the Tariff (with trade)

a. Consumer surplus is equal to: A + B + C + D + E + F.

b. Producer surplus is equal to: G.

c. Government revenue is equal to: zero.

d. Total surplus is equal to: A + B + C + D + E + F + G.

Figure 4

5. Welfare after the Tariff

a. Consumer surplus is equal to: A + B.

b. Producer surplus is equal to: C + G.

c. Government revenue is equal to: E.

d. Total surplus is equal to: A + B + C + E + G.

 6. Changes in Welfare

a. Consumer surplus changes by: –C - D - E - F).

b. Producer surplus changes by: +C.

c. Government revenue changes by: +E.

d. Total surplus changes by: –D - F.

G. FYI: Import Quotas: Another Way to Restrict Trade

1. An import quota is a limit on the quantity of a good that can be

produced abroad and sold domestically.

2. Import quotas are much like tariffs.

a. Both tariffs and quotas raise the domestic price of the good, reduce
the welfare of domestic consumers, increase the welfare of
domestic producers, and cause deadweight losses.

b. However, a tariff raises revenue for the government, whereas a

quota creates surplus for license holders.

c. A quota can potentially cause a larger deadweight loss than a tariff,

depending on the mechanism used to allocate the import licenses.

H. The Lessons for Trade Policy

1. If trade is allowed, the price of textiles will be driven to the world price.
If the domestic price is higher than the world price, the country will
become an importer and the domestic price will fall. If the domestic
price is lower than the world price, the country will become an exporter
and the domestic price will rise.

2. If a country imports a product, domestic producers are made worse off,

domestic consumers are made better off, and the gains of consumers
outweigh the losses of producers. If a country exports a product,
domestic producers are made better off, domestic consumers are
made worse off, and the gains of producers outweigh the losses of
consumers.

3. A tariff would create a deadweight loss because total surplus would fall.

I. Other Benefits of International Trade

 1. In addition to increasing total surplus, there are several other benefits
of free trade.

2. These include an increased variety of goods, lower costs through

economies of scale, increased competition, and an enhanced flow of
ideas.

III. The Arguments for Restricting Trade

A. The Jobs Argument

1. If a country imports a product, domestic producers of the product will

have to lay off workers because they will decrease domestic output
when the price declines to the world price.

2. Free trade, however, will create job opportunities in other industries

where the country enjoys a comparative advantage.

B. The National-Security Argument

1. Protecting certain industries may be appropriate if they produce

products necessary for national security.

2. In many of the cases for which this argument is used, the role of the
particular market in providing national security is exaggerated.

C. The Infant-Industry Argument

1. New industries need time to establish themselves to be able to

compete in world markets.

2. Sometimes older industries argue that they need temporary protection

to help them adjust to new conditions.

3. Even if this argument is legitimate, it is nearly impossible for the

government to choose which industries will be profitable in the future
and it is even more difficult to remove trade restrictions in an industry
once they are in place.

D. The Unfair-Competition Argument

 1. It is unfair if firms in one country are forced to comply with more
regulations than firms in another country, or if another government
subsidizes the production of a good.

2. Even if another country is subsidizing the production of a product so

that it can be exported to a country at a lower price, the domestic
consumers who import the product gain more than the domestic
producers lose.

E. The Protection-as-a-Bargaining-Chip Argument

1. Threats of protectionism can make other countries more willing to

reduce the amounts of protectionism they use.

2. If the threat does not work, the country has to decide if it would rather
reduce the economic well-being of its citizens (by carrying out the
threat) or lose credibility in negotiations (by reneging on its threat).