1 International Trade Applications Here we use changes in consumer surplus and producer surplus to see who wins and who loses with international trade being permitted in a national economy.

2 $ Q Dbt Sbt Qbt Pbt ABAB

3 On slide 2 you see - A domestic market that is not allowing international trade and the graph will be used as a basis for comparison when trade is permitted. - Dbt and Sbt are the supply and demand from domestic demanders and suppliers, respectively, before trade is permitted. - Pbt and Qbt are the equilibrium price and quantity traded, respectively, in the market without trade. - Without trade the consumer surplus is area A in the graph and the producer surplus is area B. On the next slide let’s see what happens when a product that trades at a higher price internationally than domestically is opened to trade in the domestic economy.

4 $ Q Dbt Sbt Qbt Pbt Pw World price A B C D E F QdQs

5 When the world price is higher than the domestic price and then the market is opened up to international trade then the domestic price will rise to the world price. Here is the logic. When the economy is opened the domestic producer can sell as much as desired in the world market. So, if the domestic consumer won’t pay the world price the domestic producers will just sell in other places. So the price domestically rises and consumers lose surplus by the area B and C. Also note domestic consumers buy less by the amount Qbt – Qd. With the higher price the domestic sellers benefit with producer surplus rising by B + C + D and they sell more by Qs – Qbt. Qs – Qd here is the amount exported when the world price is higher than the pre-trade price in the domestic market.

6 So, when the world price is higher than the pre-trade domestic price consumers lose and producers gain. Plus, producers gain (B + C + D) more than consumers lose (B + C) for a net gain to the country of D. Another way to say this is that producers gain everything consumers lose and they gain more. The country is thus better off with trade. Next let’s see what happens when the world price is lower than the pre-trade domestic price.

7 $ Q Dbt Sbt Qbt Pbt World price Pw A B C D E QsQd

8 When the world price is lower than the domestic price and the market is opened up to international trade then the domestic price will fall to the world price. Here is the logic. When the economy is opened the domestic consumer can buy as much as desired in the world market. So, if the domestic producer won’t sell at the world price the domestic consumers will just buy from other places. So the price domestically falls and consumers gain surplus by the area B + C + D. Also note consumers buy more by the amount Qd – Qbt. With the lower price the domestic sellers lose with producer surplus falling by B and they sell less by Qbt – Qs. Qd – Qs here is the amount imported when the world price is lower than the pre-trade price in the domestic market.

9 So, when the world price is lower than the pre-trade domestic price consumers gain and producers lose. Plus, producers lose (B) less than consumers gain (B + C + D) for a net gain to the country of C + D. Another way to say this is that consumers gain everything producers lose and they gain more. The country is thus better off with trade. Next let’s see what happens when the world price is lower than the pre-trade domestic price and after trade is opened a tariff (or tax) is imposed on the imported goods.

10 $ Q Dbt Sbt Qbt Pbt World price Pw QsQd Pw + Tariff Qs’ Qd’ A BC D E F G H I J

11 We have already established the idea that if the world price is lower than the pre-trade domestic price the country would import Qd – Qs units. Maybe government would enact a tariff. Domestic producers may be bummed out and call on a tariff to impact trade. We will assume the tariff is between Pbt and Pw. The following will be under the assumption the country is already trading internationally. The domestic price becomes Pw + the tariff. The producers gainE (from J to J + E). The consumers lose E + F + G + H + I. So producers only gain part of what consumers lose. We have to incorporate a new piece of information here – the tariff revenue.

12 Since under the tariff the new imported amount is Qd’- Qs’ and the tariff is Pw + tariff – Pw, the area G + H is the revenue to the government and is a net gain for the country. So as a whole the producers and the government gain E + G + H, While the consumers lose E + F + G + H + I. So consumers lose more than the gainers gain and the country loses by F and I. Note F and I are above the lost imports. F and I are also called the deadweight loss. The net loss is a measure of the lost output we used to get. The last story we tell here is the story of a quota, a limit on the amount of the good that is allowed to come in.

13 $ Q Dbt Sbt Qbt Pbt World price Pw QsQd

14 Notice at the world price the imported amount is Qd – Qs. Also remember earlier we said if trade is opened the price domestically will be Pw because buyers would just buy elsewhere if domestic sellers tried to sell for more. Now, with a quota, the government has to place a limit less than the current imports for the quota to be any good. Notice at the bottom of the graph I show a line segment less than the imports. Let’s say the length of this line represents the quota. The Wedge Story At the world price with the quota some consumers will not get the good – the quantity demanded will be greater than the amount supplied domestically plus the quota. So the price will rise in the domestic market above the world price and it will rise until the shortage is gone.

15 How high will the price go? Well, take that line segment I have at the bottom of the graph and push it up until it is “wedged” between the domestic supply and demand. At this point the domestic shortage will be gone. The height of the “wedge” will be the post quota price. I think you will agree that the quota looks an awful lot like the tariff, except the government doesn’t get the tariff revenue. So that part would also be lost. Sometimes the government lets a domestic firm have a license to import. Essentially they buy at world price and bring the good over and sell the quota amount at the post quota price and the importer then makes what was the tariff revenue to the government. Either way the consumers hate the quota more than the domestic producers like them in terms of the changes in surplus.