Chapter Two

The Basic Theory Using

Demand 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 coun-
try are enormous. Imagine a world in which your country 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. For the United
States, for example, start by imagining that it lived without its $300 billion a year in
imported oil. Americans would have to cut back on energy use because the remaining
domestic oil (and natural gas and other energy sources) would be more expensive.
Americans who produce oil and other energy sources might be pleased with such a
scenario. Those who work in the auto industry and those who need to heat their homes
would not. Similar impacts would be felt by producers and consumers in other parts
of the economy suddenly stripped of imports like LCD televisions and clothing. On
the export side, suppose that Boeing could sell airplanes and American farmers could
sell their crops only within the United States, and that U.S. universities could admit
only domestic students. 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
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.

13
14 Part One The Theory of International Trade

FOUR QUESTIONS ABOUT TRADE

This chapter and subsequent Chapters 3–7 tackle 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 can
we 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 chapter goes straight 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 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
 Chapter 2 The Basic Theory Using Demand and Supply 15

FIGURE 2.1
A. Demand B. Supply
Demand and
Supply for Price Price
Motorbikes ($/unit) ($/unit)
3,600
S = Supply
curve
c
2,000 2,000
v
t w
d
1,000 1,000
e
D = Demand
u curve 400 z
Quantity Quantity
40 65 (thousands) 15 40 (thousands)

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.

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’s
price. 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
The equation for this demand curve is QD 5 90,000 2 25P (or P 5 3,600 2 0.04QD).
16 Part One The Theory of International Trade

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 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 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
 Chapter 2 The Basic Theory Using Demand and Supply 17

Case Study Trade Is Important

To understand stories about how trade works, relatively less of primary products, especially
it is useful to know some of the key facts about fuels. In manufactured products, industrialized
trade. A good start is a broad overview of the countries export relatively more of chemicals,
products traded and trade’s growing importance. while developing countries export relatively more
How large is international trade? What prod- of textiles and clothing. Industrialized countries
ucts are traded? The table below shows exports are relatively strong in exporting services. We will
by major product categories, for the world overall use this kind of observation—looking at trade
and for two broad economic groups of countries, across product categories—as we examine why
the industrialized (or developed or advanced) countries trade with each other.
countries and the developing countries. How important is international trade in the
In 2012, world trade was nearly $23 trillion, economies of various countries? The second table
with the industrialized countries contributing in this box examines one measure of the impor-
a little over half of world exports. Most goods tance of trade to a country, the ratio of the sum
are traded across national borders, as are many of a country’s total trade (exports plus imports)
services, including transportation, computer and to the country’s gross domestic product (GDP, a
information services, as well as insurance, con- standard way of measuring the size of a country’s
sulting, and educational services. For the world, economy). These measures are not completely
about half of trade is in manufactured products, comparable (exports and imports measure full
with the rest of trade split between primary prod- sales values, while GDP measures value added).
ucts and services. By comparing the details across Still, they provide a reasonable way of comparing
the columns, we can see that the broad pattern the importance of trade across time and across
of exporting by the industrialized countries has countries.
some differences from the pattern for develop- Here are a few observations about what we
ing countries. Industrialized countries export see in this table. First, for each of the countries

Exports, 2012 (billions of U.S. dollars)

Industrialized Developing
World Countries Countries
Total 22,777 12,283 10,494
Primary products 6,293 2,454 3,839
Agricultural 1,666 942 724
Fuels 3,451 927 2,524
Ores 1,176 585 590
Manufactured products 11,486 6,426 5,060
Chemicals 1,945 1,349 596
Machinery and transport equipment 5,829 3,247 2,582
Textiles and clothing 733 213 520
Other 2,979 1,617 1,362
Services 4,426 2,951 1,475

Note: Sum of primary products, manufactured products, and services does not equal total because of a
small amount of unclassified goods.
Source: UNCTAD, UNCTADStat.
—Continued on next page
18 Part One The Theory of International Trade

Exports Plus Imports as a Percentage of GDP rising international transactions increasingly link
together what had been relatively separate
1970 2012
national economies. Second, trade tends to be
United States 11.1 30.4 more important for countries with smaller econ-
Canada 42.0 62.1 omies (such as Canada and Denmark) and some-
Japan 20.3 31.3 what less important for very large economies
France 31.1 57.1 (such as the United States and Japan). Third,
United Kingdom 43.6 65.3 both China and India have gone from being
Australia 25.9 41.5 mostly closed to trade to much more open and
Denmark 57.3 104.5 involved. The experiences of China and India in
China 5.3 51.3 the past several decades are rather close to the
India 8.0 55.4 approach we will take in Chapters 2–7—imagin-
Korea 37.7 109.9 ing a national economy with no trade and then
Brazil 14.9 26.5 drawing out what will happen when the country
opens up to free trade.
Source: International Monetary Fund, International
Financial Statistics. DISCUSSION QUESTION
shown in the table (and for most other coun- Given the trends shown here, do you think that
tries), international trade has become more international trade should have become more
important. Trade’s increasing importance is one controversial or less controversial than it was
part of the process of globalization—in which several decades ago?

Figure 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 smaller
triangle (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, plus
the 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
 Chapter 2 The Basic Theory Using Demand and Supply 19

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 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—supply
is 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 prod-
uct. 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 hits the axis. This amount just covers the extra cost of producing and

2
The equation for this supply curve is QS 5 210,000 1 25P (or P 5 400 1 0.04QS).
20 Part One The Theory of International Trade

Global Crisis The Trade Mini-Collapse of 2009

The global crisis that began in 2007 and deep- 6 (from the initial 100 in 1960 to about 600 in
ened in late 2008 spread well beyond financial 2013). Since 1960, world trade has increased by a
markets. The crisis caused the first large-scale factor of over 20. This is another way to see what
downturn in world trade in more than half a cen- we highlighted in the previous box—the increas-
tury, ending decades in which, nearly year after ing importance of trade.
year, international trade grew faster than world The diagram also shows the surprising recent
production. First, let’s look at the growth of trade decline of world trade. Starting in late 2008,
over decades, then we’ll examine the unexpected world trade declined by about 11 percent. The
mini-collapse. trade decline was much larger than the 2 percent
The diagram shows world exports of goods decline in world production. Why was the trade
and services and world production of goods and decline so large? Two specific features matter.
services. Each is adjusted for price inflation, so First, a relatively large part of trade is in durable
we are seeing what happened to the quantity or goods like machinery and automobiles. In the crisis-
volume. Each is measured as an index number, driven global recession, purchases of durable goods
with its value set to be equal to 100 in 1960. were postponed or canceled, and trade in these
Using the index values, we can see how each has products collapsed. The trade decline was ampli-
changed during the past half century. fied because production of these products often
Looking at the entire time period, the explo- involves a global supply chain in which materials
sive growth of world exports is clear. Since 1960, and components are traded across borders before
world production has increased by a factor of final assembly. A decrease of, say, $100 in the sale

Volume of World Trade and World Production, 1960–2013

2,100

1,900

1,700

1,500
Index (1960 = 100)

1,300
World exports
1,100

900

700

500

300
World production
100
1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

Source: World Bank, World Development Indicators.

 Chapter 2 The Basic Theory Using Demand and Supply 21

of a final good can result in a decrease of well more The collapse in world trade in 2009 resur-
than $100 in the cumulated value of trade in mate- rected memories of the Great Depression of the
rials, components, and the final good itself. Second, 1930s, when trade declined by 25 percent during
but of much less importance, most trade requires the four years from 1929 to 1933. Fortunately for
financing, and there was some crisis-driven decline the world, and for us, the recent decline in trade
in working-capital financing for export production was a mini-collapse, and robust trade growth
and in trade financing for export–import transac- returned beginning in mid-2009. Then, the euro
tions. For both of these reasons, the crisis-recession crisis that began in 2010 caused some slowdown
decline in world production and final sales led to a in the growth rate of world exports in 2012 and
magnified decline in world trade. 2013, but not an actual decline in trade volume.

selling this first unit. The supply curve tells us that some producer is willing to supply
the 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 1 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 surplus
is the difference between total revenues (area e 1 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 1 v,
22 Part One The Theory of International Trade

FIGURE 2.2 Price

The Market for ($/unit)
Motorbikes:
Demand and 3,600
Supply S = Supply
curve
c A
2,000
h

D = Demand
400 g
curve
Quantity
0 40 (thousands)

The market for motorbikes can be pictured using demand and supply curves. In this example,
which may be a national market with no international trade, the market reaches equilibrium at a
price of $2,000 per motorbike, with 40,000 motorbikes produced and purchased during the time
period (e.g., a year). Under these conditions, consumers get consumer surplus equal to area c and
producers get producer surplus equal to area h.

or ($2,000 2 $1,000) 3 15,000 plus (l/2) 3 ($2,000 2 $1,000) 3 (40,000 2

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 anyway
at 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 1 w 1 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 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
 Chapter 2 The Basic Theory Using Demand and Supply 23

FIGURE 2.3 The Effects of Trade on Production, Consumption, and Price, Shown with Demand and
Supply Curves

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

Motorbike Market Motorbike Market Motorbike Market
Price Price Price
($/unit) ($/unit) ($/unit)
SUS
A
2,000 2,000
U.S. pretrade World price
price with trade
Exports Sf
C B F E Sx
1,000 1,000 1,000
I J
Imports 700 700 H
DUS
Dm Df

15 40 65 Quantity 50 Quantity 25 50 75 Quantity

(thousands) (thousands) (thousands)
SUS = U.S. supply Sx = Rest-of-world supply of exports Sf = Rest of world’s supply
DUS = U.S. demand (Sx = Sf – Df) Df = Rest of world’s demand
Dm = U.S. demand for imports
(Dm = DUS – SUS)

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.

Effects of Trade Price Quantity Supplied Quantity Demanded

United States Down Down Up
Rest of the world Up Up Down

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.
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.
24 Part One The Theory of International Trade

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.
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.
 Chapter 2 The Basic Theory Using Demand and Supply 25

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 Motorbike Market
Price Price Price
($/unit) ($/unit) ($/unit)
SUS
c A
2,000 2,000
U.S. pretrade World price
a price with trade

b d b+d Exports Sf
C B F E Sx
1,000 1,000 1,000
e n j I k n J
Imports 700 700 H
DUS
Dm Df

15 40 65 Quantity 50 Quantity 25 50 75 Quantity

(thousands) (thousands) (thousands)
SUS = U.S. supply Sx = Rest-of-world supply of exports Sf = Rest of world’s supply
DUS = U.S. demand Dm = U.S. demand for imports Df = Rest of world’s demand

Welfare Effects of Free Trade

United States Rest of the World
Surplus with Surplus with Net Effect Net Effect
Group Free Trade No Trade of Trade Group of Trade
Consumers a1b1c1d c a1b1d Consumers 2 ( j 1 k) [a loss]
Producers e a1e 2 a [a loss] Producers j1k1n
U.S. as a whole
(consumers plus Rest of the world
producers) a1b1c1d1e c1a1e b1d as a whole n
26 Part One The Theory of International 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
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-being
to be a matter better handled by compensating those hurt by a change or by using some
3
Figure 2.4 does not enable us to identify the “producers” experiencing these losses of producer surplus.
If one views the supply curve as the marginal cost curve for competitive entrepreneurs who face fixed
prices for inputs, then the change in producer surplus is the change in these entrepreneurs’ profits.
Taking this approach implicitly assumes that workers and suppliers of capital are completely unaffected by
the fortunes of the industry because they can just take their labor and capital elsewhere and earn exactly
the same returns. Yet this narrow focus is not justified, either by the real world or by the larger model
that underlies the demand and supply curves.
Though the present diagrams cannot show the entire model of international trade at once, they
are based on a general equilibrium model that shows how trade affects the rates of pay of productive
inputs as well as product prices and quantities. As we shall see in Chapter 5, anything that changes the
relative price of a product also changes the distribution of income within the nation. The issue of how
trade affects the distribution of income will be taken up later. Now the key point is simply that as the
price of motorbikes drops and the economy moves from point A to point C, the producer surplus being
lost probably is a loss to workers and other input suppliers to the industry, not just a loss to the industry’s
entrepreneurs. To know how the change in producer surplus is divided among these groups, one would
have to consult the full model, which will be complete by the end of Chapter 5.
 Chapter 2 The Basic Theory Using Demand and Supply 27

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 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
5
Rest of world’s gain y
28 Part One The Theory of International Trade

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.

Summary: Extending the familiar demand2supply framework to international trade has given us
Early useful preliminary answers to the four basic questions about international trade. The
contrast between no trade and free trade offers these conclusions:
Answers
to the 1. Why do countries trade? Demand and supply conditions differ between coun-
tries, so prices differ between countries if there is no international trade. Trade
Four begins as someone conducts arbitrage to earn profits from the price difference
Trade between previously separated markets. A product will be exported from coun-
Questions 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 whose prices are disrupted more by trade gains more.
4. Within each country, who are the gainers and losers from opening trade? The gainers
are the consumers of imported products and the producers of exportable products.
Those who lose are the producers of import-competing products and the consumers of
exportable products.

Key Terms Elasticity Opportunity cost Supply of exports

Price elasticity of Producer surplus One-dollar, one-vote
demand Arbitrage metric
Consumer surplus International price Net national gains from
Price elasticity of World price trade
supply Demand for imports
 Chapter 2 The Basic Theory Using Demand and Supply 29

Suggested Suranovic (2000) discusses seven types of fairness and applies them to international
trade. He calls our one-dollar, one-vote metric “maximum benefit fairness.” Bems et al.
Reading
(2013) survey the causes of the 2009 trade collapse.

Questions ✦ 1. What is consumer surplus? Using real-world data, what information would you need
to measure consumer surplus for a product?
and
2. What is producer surplus? Using real-world data, what information would you need
Problems to measure producer surplus for a product?
✦ 3. How can a country’s supply and demand curves for a product be used to determine the
country’s supply-of-exports curve? What does the supply-of-exports curve mean?
4. How can a country’s supply and demand curves for a product be used to determine the
country’s demand-for-imports curve? What does the demand-for-imports curve mean?
✦ 5. A tropical country can produce winter coats, but there is no domestic demand for these
coats. Explain how this country can gain from free trade in winter coats.
6. The United States exports a substantial amount of scrap iron and steel to Turkey,
China, Canada, and other countries. Why do some U.S. users of scrap iron and steel
support a prohibition on these exports?
✦ 7. Explain what is wrong with the following statement: “Trade is self-eliminating.
Opening up trade opportunities drives prices and costs into equality between coun-
tries. But once prices and costs are equalized, there is no longer any reason to trade
the product from one country to another, and trade stops.”
8. In 2012, the United States imported about 3.1 billion barrels of oil. Perhaps it would
be better for the United States if it could end the billions of dollars of payments to
foreigners by not importing this oil. After all, the United States can produce its own
oil (or other energy products that substitute for oil). If the United States stopped all
oil imports suddenly, it would be very disruptive. But perhaps the United States could
gain if it gradually restricted and then ended oil imports in an orderly transition. If we
allow time for adjustments by U.S. consumers and producers of oil, and we perhaps
are optimistic about how much adjustment is possible, then the following two equa-
tions show domestic demand and supply conditions in the United States:
Demand: P 5 364 2 48·QD
Supply: P 5 4 1 40·QS
where quantity Q is in billions of barrels per year and price P is in dollars per barrel.
a. With free trade and an international price of $100 per barrel, how much oil does
the United States produce domestically? How much does it consume? Show the
demand and supply curves on a graph and label these points. Indicate on the graph
the quantity of U.S. imports of oil.
b. If the United States stopped all imports of oil (in a way that allowed enough time for
orderly adjustments as shown by the equations), how much oil would be produced
in the United States? How much would be consumed? What would be the price of
oil in the United States with no oil imports? Show all of this on your graph.
c. If the United States stopped all oil imports, which group(s) in the United States would
gain? Which group(s) would lose? As appropriate, refer to your graph in your answer.
30 Part One The Theory of International Trade

✦ 9. Consider Figure 2.3, which shows free trade in motorbikes. Assume that consumers
in the United States shift their tastes in favor of motorbikes. What is the effect on the
U.S. domestic demand and/or supply curve(s)? What is the effect on the U.S. demand-
for-imports curve? What is the effect on the equilibrium international price?
10. Consider again Figure 2.3, which shows free trade in motorbikes. Assume that U.S.
productivity in producing motorcycles increases. What is the effect on the U.S.
domestic demand and/or supply curve(s)? What is the effect on the U.S. demand-for-
imports curve? What is the effect on the equilibrium international price?
✦ 11. Consider a two-country world. Each country has an upward-sloping national supply
curve for raisins and a downward-sloping national demand curve for raisins. With no
trade in raisins, the no-trade equilibrium price for raisins in one country would be
$2.00 per kilogram and the no-trade equilibrium price for raisins in the other coun-
try would be $3.20 per kilogram. If the countries allow free trade in raisins, explain
why $3.50 per kilogram cannot be the free-trade equilibrium world price for raisins.
In your answer, draw and refer to graphs of supply and demand curves for the two
national markets.
12. Consider a world in which everyone agrees that changes in consumers’ well-being are
more important than changes in producers’ well-being in analyzing the effects of free
trade in furniture. (This belief is a deviation from the one-dollar, one-vote metric.)
Does the importing country still gain from free trade in furniture? Does the exporting
country still gain from free trade in furniture?
✦ 13. The equation for the demand curve for writing paper in Belgium is

QD 5 350 2 (P/2) [or P 5 700 2 2QD]

The equation for the supply curve for writing paper in Belgium is

QS 5 2200 1 5P [or P 5 40 1 (QS/5)]

a. What are the equilibrium price and quantity if there is no international trade?
b. What are the equilibrium quantities for Belgium if the nation can trade freely with
the rest of the world at a price of 120?
c. What is the effect of the shift from no trade to free trade on Belgian consumer
surplus? On Belgian producer surplus? What is the net national gain or loss for
Belgium?
14. Country I has the usual demand and supply curves for Murky Way candy bars. Country II
has a typical demand curve, too, but it cannot produce Murky Way candy bars.
a. Use supply and demand curves for the domestic markets and for the international
market. Show in a set of graphs the free-trade equilibrium for Murky Way candy
bars. Indicate the equilibrium world price. How does this world price compare to
the no-trade price in Country I? Indicate how many Murky Ways are traded during
each time period with free international trade.
b. Show graphically and explain the effects of the shift from no trade to free trade on
surpluses in each country. Indicate the net national gain or loss from free trade for
each country.