TRADE POLICY I. International Trade A. The Equilibrium without Trade 1. Without Trade: If there is no trade, the domestic price in that market will balance supply and demand (Figure 1). 2. With Trade: a. If the government allows trade, what will happen to the price of the commodity and the quantity 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 commodity) be part of the new trade policy? Figure 1
Figure 1

B. The Equilibrium with Free Trade -- The World Price and Comparative Advantage 1. The first issue is to decide whether the country should import or export a commodity. a. The answer depends on the relative price of the commodity in that country compared with the price in foreign 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, the country should export the commodity; if the world price is lower than the domestic price, the country should import the commodity. a. Note that the domestic price represents the opportunity cost of producing the commodity in the country, while the world price represents the opportunity cost of producing abroad. b. Thus, if the domestic price is low, this implies that the opportunity cost of producing the commodity at in domestic economy is low, suggesting that the country has a comparative advantage in the production of that commodity. 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
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
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