Mankiw: Principles of Microeconomics - Chapter 9 Study Notes
Principles of Microeconomics - Chapter 9: Application: International Trade
Chapter Objectives (1 of 2)
By the end of this chapter, you should be able to:
Determine whether a country will be an importer or exporter of a good if the country opens up to international trade.
Determine the impact of a tariff on imports and government revenue, given a domestic supply and demand graph.
Determine the impact of the world price on domestic production and domestic consumption.
Analyze the change in economic welfare when a previously closed economy begins exporting goods.
Chapter Objectives (2 of 2)
Analyze the change in economic welfare when a previously closed economy begins importing goods.
Indicate the area representing deadweight loss caused by a tariff, given a domestic supply and demand graph.
Compare the effect of a quota versus a tariff on an open economy.
Identify which argument for restricting trade is being applied, given a proposed trade restriction.
The Determinants of Trade
The Equilibrium without Trade
In a closed economy, only domestic buyers and sellers participate in the market.
The equilibrium price and quantity are determined through the balance of quantity supplied by domestic sellers and quantity demanded by domestic buyers.
Total economic benefits in this scenario are represented by the sum of consumer surplus and producer surplus.
Figure 1: The Equilibrium without International Trade
This figure illustrates the consumer and producer surplus in an equilibrium without international trade, using the textile market in Isoland as an example.
Domestic Price and World Price
World Price: The prevailing price of a good in the global marketplace.
Domestic Price: The price of a good that exists in the domestic market when there is no trade.
Comparative Advantage
If the world price is greater than the domestic price ($P{world} > P{domestic}$), this indicates that the domestic country possesses a comparative advantage and thus will export the good.
Conversely, if the world price is less than the domestic price ($P{world} < P{domestic}$), the domestic country does not have a comparative advantage and will import the good.
The Winners and Losers from Trade
Small-Economy Assumption
A small economy operates as a price taker in global markets, meaning it cannot influence the world price with its own actions.
When engaging in free trade, the world price becomes the sole relevant price for that economy.
No seller would accept less than the world price, as they can sell their goods globally, and no buyer would pay more than the world price, as they have access to the same goods from global markets.
The Gains and Losses of an Exporting Country
Before Trade
In a closed economy, the domestic equilibrium price is lower than the world price.
After Trade
Once trade is enabled, the domestic price aligns with the world price, where domestic quantity supplied exceeds domestic quantity demanded, resulting in exports.
Figure 2: International Trade in an Exporting Country
Comparison before and after trade illustrates shifts in consumer and producer surplus:
Consumer Surplus: They experience a decrease with a reduction from $A + B$ to $A$.
Producer Surplus: This increases from $C$ to $B + C + D$.
Total Surplus rises by the amount indicated as area $D$, representing gains from trade.
Welfare Analysis of an Exporting Country
Before Trade
Total surplus is the sum of consumer surplus and producer surplus.
After Trade
There is a decrease in consumer surplus, an increase in producer surplus, and a net increase in total surplus.
Conclusion
When a country becomes an exporter, domestic consumers suffer losses while domestic producers gain; however, the overall economic well-being of the nation improves, with the gains of the winners outweighing the losses of the losers.
The Gains and Losses of an Importing Country
Before Trade
For a closed economy, the domestic equilibrium price exceeds the world price.
After Trade
Domestic price adjusts to the world price, leading to lower domestic quantity supplied than quantity demanded, resulting in imports.
Figure 3: International Trade in an Importing Country
Again, an examination before and after trade:
Consumer Surplus: This rises from $A$ to $A + B + D$.
Producer Surplus: This decreases from $B + C$ to $C$.
Total Surplus increases by the area labeled $D$ after trade.
Welfare Analysis of an Importing Country
Before Trade
Total surplus encompasses the sum of consumer and producer surpluses.
After Trade
Consumer surplus rises, while producer surplus decreases, yet total surplus shows an overall increase.
Conclusion
In the case of becoming an importer, domestic consumers benefit while domestic producers face disadvantages, but the overall economic welfare is enhanced, following the same principle that gains from trade exceed losses.
The Effects of a Tariff
Tariff Defined
A Tariff is a tax levied on imported goods, imposing additional costs on foreign products.
Effects Before Tariff
Initially, the domestic price is equivalent to the world price under free trade conditions.
Effects After Tariff
Post-tariff, the domestic price rises to equal the world price plus the tariff amount.
The Impact of a Tariff
Implementing a tariff leads to reduced import quantities, moving the domestic market back towards its without-trade equilibrium.
It results in increased government tax revenue but decreases total surplus, creating deadweight loss.
Figure 4: The Effects of a Tariff
The figure demonstrates the changes in consumer and producer surplus before and after tariff imposition, including the government revenue acquired from tariffs and the falling total surplus represented by the deadweight loss areas $D + F$.
Lessons for Trade Policy
Key Considerations
Engage with considerations including domestic market prices, whether a country should export or import based on its comparative advantage, and who stands to gain or lose from free trade.
Emphasize that the net benefits from trade generally exceed losses.
Should Tariffs be Enacted?
While tariffs can propel the economy closer to a no-trade equilibrium, they also incur deadweight losses.
The ideal policy framework would thus advocate for trade facilitation without imposing tariffs.
Other Benefits of International Trade
Greater variety of goods.
Cost reductions through economies of scale.
Heightened competition.
Increased productivity among industries.
Enhanced dissemination of ideas and innovation.
The Arguments for Restricting Trade
The Jobs Argument
Acknowledgement that job losses can accompany trade expansion, yet it's essential to recognize that free trade simultaneously fosters new job creation in export sectors.
The National-Security Argument
Emphasizes the necessity of protecting crucial industries linked to national security, while being wary of industries that may exaggerate their importance.
The Infant-Industry Argument
Suggests that nascent industries may require temporary trade barriers for development, but acknowledges difficulty in effectively managing such policies.
The Unfair-Competition Argument
Argues that unfilled trade regulations create an uneven playing field, impacting domestic producers negatively despite the aggregate benefits to consumers.
The Protection-as-a-Bargaining-Chip Argument
Points out that while trade restrictions can potentially secure concessions from trade partners, the practical implications may involve reduced economic welfare.
Conclusion
Public Perspective
Public opinion remains conflicted regarding trade's role as either an opportunity or a threat, influencing political discourse.
Economic Perspective
Economists largely advocate free trade for its role in leveling production efficiency and improving living standards both domestically and internationally.
Think-Pair-Share Activity
Engage with the concept of free versus fair trade, contemplating the economic impacts of restricting trade in cases of subsidized foreign production and the potential outcomes of threatening trade restrictions to negotiate better terms.
Self-Assessment
Reflect on how international trade affects overall economic welfare and analyze winners and losers in trade dynamics, assessing the comparative magnitude of gains against losses.
Summary
Further review the objectives as defined at the start of the chapter to consolidate understanding and application of the key principles discussed throughout this chapter.
Chapter Objectives (1 of 2)
By the end of this chapter, you should be able to:
Determine whether a country will be an importer or exporter of a good if the country opens up to international trade, based on the comparison of domestic price and world price.
Determine the precise impact of a tariff on imports, domestic production, domestic consumption, and government revenue, given a domestic supply and demand graph, and quantify the resulting deadweight loss.
Determine the impact of the world price on domestic production and domestic consumption, illustrating how market forces adjust under free trade.
Analyze the change in economic welfare when a previously closed economy begins exporting goods, identifying the winners and losers and the net societal gain.
Chapter Objectives (2 of 2)
Analyze the change in economic welfare when a previously closed economy begins importing goods, identifying the winners and losers and the net societal gain, emphasizing the overall increase in total surplus.
Indicate the precise area representing deadweight loss caused by a tariff, given a domestic supply and demand graph, and explain its implications for economic efficiency.
Compare the effect of a quota versus a tariff on an open economy, considering their ultimate impact on prices, quantities, and efficiency.
Identify which argument for restricting trade is being applied, given a proposed trade restriction, and critically evaluate its economic validity and potential pitfalls.
The Determinants of Trade
The Equilibrium without Trade
In a closed economy, also known as an autarky, only domestic buyers and sellers participate in the market, with no international exchange of goods or services.
The equilibrium price and quantity are determined at the intersection of the domestic supply and demand curves, where the quantity supplied by domestic sellers precisely balances the quantity demanded by domestic buyers.
Total economic benefits in this scenario are represented by the sum of consumer surplus and producer surplus. Consumer surplus is the benefit consumers receive when they pay less than they are willing to pay, while producer surplus is the benefit producers receive when they sell at a price higher than their cost of production. This sum represents the total welfare generated in a self-sufficient market.
Figure 1: The Equilibrium without International Trade
This figure visually illustrates the consumer surplus (area below the demand curve and above the equilibrium price) and producer surplus (area above the supply curve and below the equilibrium price) in an equilibrium without international trade, using the textile market in Isoland as a concrete example.
Domestic Price and World Price
World Price (P_{ ext{world}}
): The prevailing price of a good in the global marketplace, determined by the global supply and demand for that good. It represents the opportunity cost of obtaining goods internationally.Domestic Price (P_{ ext{domestic}}
): The price of a good that exists in the domestic market when there is no trade. This price reflects the domestic supply and demand conditions without external influence.
Comparative Advantage
If the world price is greater than the domestic price (P{ ext{world}} > P{ ext{domestic}}
), this indicates that the domestic country can produce the good at a lower opportunity cost relative to the rest of the world. Therefore, the domestic country possesses a comparative advantage and will efficiently export the good to global markets.Conversely, if the world price is less than the domestic price (P{ ext{world}} < P{ ext{domestic}}
), the domestic country's opportunity cost of producing the good is higher than the world's. In this scenario, the domestic country does not have a comparative advantage and will find it more efficient to import the good from other countries.
The Winners and Losers from Trade
Small-Economy Assumption
A small economy operates as a price taker in global markets, meaning its purchases or sales are so small relative to the global market that it cannot influence the world price with its own actions. Its domestic policies, therefore, do not affect international prices.
When engaging in free trade, the world price becomes the sole relevant price for that economy. No domestic seller would accept less than the world price, as they can readily sell their goods globally at that price. Similarly, no domestic buyer would pay more than the world price, as they have access to the same goods from global markets at the world price.
The Gains and Losses of an Exporting Country
Before Trade
In a closed economy, the domestic equilibrium price is lower than the world price (P{ ext{domestic}} < P{ ext{world}}
), signifying a domestic comparative advantage.At this lower domestic price, domestic quantity supplied equals domestic quantity demanded.
After Trade
Once trade is enabled, the domestic price aligns with the world price. This higher price incentivizes domestic producers to increase their quantity supplied, while domestic consumers reduce their quantity demanded.
The surplus of domestic quantity supplied over domestic quantity demanded is then exported to the global market.
Figure 2: International Trade in an Exporting Country
This figure illustrates the comparison of consumer and producer surplus before and after trade in an exporting country:
Consumer Surplus: Consumers experience a decrease because the price rises from the domestic equilibrium to the world price. Their surplus is reduced from areas A + B to just A.
Producer Surplus: Producers benefit significantly from the higher world price, increasing their surplus from C to B + C + D.
Total Surplus: The overall total surplus for the nation rises by the amount indicated as area D, which represents the net gains from trade. This area D signifies the efficiency gains from allowing the country to specialize and export.
Welfare Analysis of an Exporting Country
Before Trade
Total surplus is the sum of consumer surplus (A + B) and producer surplus (C), resulting in A + B + C.
After Trade
There is a decrease in consumer surplus (loss of B), an increase in producer surplus (gain of B + D), and a net increase in total surplus (D is gained).
The new total surplus becomes A + B + C + D.
Conclusion
When a country becomes an exporter, domestic consumers suffer losses due to higher prices, while domestic producers gain substantially from increased sales and revenue. However, the overall economic well-being of the nation improves, with the gains of the winners (producers) outweighing the losses of the losers (consumers), leading to a net increase in total economic welfare.
The Gains and Losses of an Importing Country
Before Trade
For a closed economy, the domestic equilibrium price exceeds the world price (P{ ext{domestic}} > P{ ext{world}}
), indicating that the country does not have a comparative advantage in production.At this higher domestic price, domestic quantity supplied equals domestic quantity demanded.
After Trade
Once trade is enabled, the domestic price adjusts downward to the world price. This lower price incentivizes domestic consumers to increase their quantity demanded, while domestic producers reduce their quantity supplied.
The shortage between domestic quantity demanded and domestic quantity supplied is then met by imports from the global market.
Figure 3: International Trade in an Importing Country
Again, an examination before and after trade illustrates shifts in consumer and producer surplus:
Consumer Surplus: Consumers benefit from the lower world price, experiencing a rise in surplus from A to A + B + D.
Producer Surplus: Producers face disadvantages due to the lower price and reduced sales, with their surplus decreasing from B + C to just C.
Total Surplus: The overall total surplus for the nation increases by the area labeled D after trade, representing the net gains from importing.
Welfare Analysis of an Importing Country
Before Trade
Total surplus encompasses the sum of consumer (A) and producer surpluses (B + C), totaling A + B + C.
After Trade
Consumer surplus rises (gain of B + D), while producer surplus decreases (loss of B), yet total surplus shows an overall increase (D is gained).
The new total surplus becomes A + B + C + D.
Conclusion
In the case of becoming an importer, domestic consumers benefit significantly from lower prices and greater availability of goods, while domestic producers face disadvantages due to increased competition and lower sales. However, the overall economic welfare is enhanced, following the same principle that gains from trade (to consumers) exceed losses (to producers), leading to a net increase in total economic welfare.
The Effects of a Tariff
Tariff Defined
A Tariff is a specific type of tax levied on imported goods or services, imposing additional costs on foreign products as they enter the domestic market. Tariffs can be specific (a fixed charge per unit of the imported good) or ad valorem (a fixed percentage of the value of the imported good).
Effects Before Tariff
Initially, under free trade conditions, the domestic price is equivalent to the world price (P{ ext{domestic}} = P{ ext{world}}
), meaning consumers pay the global market price and imports fill the gap between domestic demand and supply.
Effects After Tariff
Post-tariff, the domestic price rises to equal the world price plus the tariff amount (P{ ext{domestic}} = P{ ext{world}} + ext{Tariff}
). This increase in price makes imported goods more expensive for domestic consumers.
The Impact of a Tariff
Implementing a tariff leads to reduced import quantities as the higher domestic price discourages demand and encourages domestic production. This moves the domestic market back towards its without-trade equilibrium, but at a higher price and lower quantity than under free trade.
It results in increased government tax revenue (from collecting the tariff on each imported unit), but simultaneously decreases total surplus due to inefficient allocation of resources, creating a deadweight loss. This loss arises because the tariff prevents some mutually beneficial trades from occurring and diverts production from more efficient foreign producers to less efficient domestic producers.
Figure 4: The Effects of a Tariff
The figure demonstrates the changes in consumer and producer surplus before and after tariff imposition:
Consumer Surplus: Significantly decreases due to the higher domestic price.
Producer Surplus: Increases because domestic producers can sell more goods at a higher price.
Government Revenue: A new area representing the tariff revenue collected by the government (quantity of imports multiplied by the tariff per unit).
Falling Total Surplus: The total surplus decreases, and this reduction is represented by the areas identified as deadweight loss (D + F). Area D represents the loss from underconsumption (consumers buying less due to higher prices), and area F represents the loss from overproduction by less efficient domestic firms (inefficient resource allocation away from production based on comparative advantage).
Lessons for Trade Policy
Key Considerations
Engage with considerations including domestic market prices, whether a country should export or import based on its comparative advantage (determining the optimal role in global trade), and critically assessing who stands to gain or lose from free trade and by how much.
Emphasize that the net benefits from trade generally exceed losses, implying a positive aggregate impact on national welfare, even though specific groups may be harmed.
Should Tariffs be Enacted?
While tariffs can propel the economy closer to a no-trade equilibrium by raising domestic prices and reducing imports, they inherently incur deadweight losses, leading to a suboptimal allocation of resources and reduced overall welfare.
The ideal policy framework would thus advocate for trade facilitation without imposing tariffs, focusing on maximizing efficiency and total surplus through free market mechanisms.
Other Benefits of International Trade
Greater variety of goods: Consumers gain access to a wider array of products, technologies, and services from around the world, enhancing choice and satisfaction.
Cost reductions through economies of scale: Firms can expand their markets globally, allowing them to produce at larger scales, achieve lower average costs, and pass some of these savings to consumers.
Heightened competition: International trade forces domestic firms to become more efficient and innovative to compete with foreign counterparts, benefiting consumers with better quality and lower prices.
Increased productivity among industries: Specialization according to comparative advantage allows countries to focus resources on industries where they are most productive, leading to overall national productivity gains.
Enhanced dissemination of ideas and innovation: The exchange of goods often facilitates the transfer of technology, management practices, and cultural ideas, fostering innovation and economic growth globally.
The Arguments for Restricting Trade
The Jobs Argument
Acknowledgement that trade expansion can lead to job losses in import-competing domestic industries as production shifts to more efficient foreign suppliers. However, it's essential to recognize that free trade simultaneously fosters new job creation in export sectors and industries that support increased trade, often leading to a reallocation of labor rather than a net loss of jobs.
The National-Security Argument
Emphasizes the necessity of protecting crucial industries linked to national security (e.g., defense, essential food, energy) to prevent dependence on potentially hostile foreign suppliers. However, there's a need to be wary of industries that may exaggerate their importance to national security purely for economic protection.
The Infant-Industry Argument
Suggests that nascent industries in developing countries may require temporary trade barriers (protection from mature foreign competition) to grow, achieve economies of scale, and become competitive. Acknowledges difficulty in effectively identifying truly promising infant industries and managing such policies without them becoming permanent or fostering inefficiency.
The Unfair-Competition Argument
Argues that trade is unfair if foreign producers operate under different regulations (e.g., lower environmental standards, government subsidies, different labor laws), impacting domestic producers negatively. While these concerns are valid in terms of producer welfare, consumers often benefit from the cheaper goods that result from such
Here is a list of key terms and their definitions from the notes:
Closed economy: Also known as an autarky, only domestic buyers and sellers participate in the market, with no international exchange of goods or services.
Consumer surplus: The benefit consumers receive when they pay less than they are willing to pay.
Producer surplus: The benefit producers receive when they sell at a price higher than their cost of production.
World Price (P_{\text{world}}): The prevailing price of a good in the global marketplace, determined by the global supply and demand for that good. It represents the opportunity cost of obtaining goods internationally.
Domestic Price (P_{\text{domestic}}): The price of a good that exists in the domestic market when there is no trade. This price reflects the domestic supply and demand conditions without external influence.
Comparative Advantage: When a domestic country can produce a good at a lower opportunity cost relative to the rest of the world, leading it to efficiently export that good to global markets.
Small economy: Operates as a price taker in global markets, meaning its purchases or sales are so small relative to the global market that it cannot influence the world price with its own actions. Its domestic policies, therefore, do not affect international prices.
Tariff: A specific type of tax levied on imported goods or services, imposing additional costs on foreign products as they enter the domestic market. Tariffs can be specific (a fixed charge per unit of the imported good) or ad valorem (a fixed percentage of the value of the imported good).
Deadweight loss: A reduction in total surplus due to inefficient allocation of resources, which arises because trade restrictions like tariffs prevent some mutually beneficial trades from occurring and divert production from more efficient foreign producers to less efficient domestic producers.
Here is a list of key terms and their definitions from the notes:
Closed economy: Also known as an autarky, only domestic buyers and sellers participate in the market, with no international exchange of goods or services.
Consumer surplus: The benefit consumers receive when they pay less than they are willing to pay.
Producer surplus: The benefit producers receive when they sell at a price higher than their cost of production.
World Price (P_{\text{world}}): The prevailing price of a good in the global marketplace, determined by the global supply and demand for that good. It represents the opportunity cost of obtaining goods internationally.
Domestic Price (P_{\text{domestic}}): The price of a good that exists in the domestic market when there is no trade. This price reflects the domestic supply and demand conditions without external influence.
Comparative Advantage: When a domestic country can produce a good at a lower opportunity cost relative to the rest of the world, leading it to efficiently export that good to global markets.
Small economy: Operates as a price taker in global markets, meaning its purchases or sales are so small relative to the global market that it cannot influence the world price with its own actions. Its domestic policies, therefore, do not affect international prices.
Tariff: A specific type of tax levied on imported goods or services, imposing additional costs on foreign products as they enter the domestic market. Tariffs can be specific (a fixed charge per unit of the imported good) or ad valorem (a fixed percentage of the value of the imported good).
Deadweight loss: A reduction in total surplus due to inefficient allocation of resources, which arises because trade restrictions like tariffs prevent some mutually beneficial trades from occurring and divert production from more efficient foreign producers to less efficient domestic producers.
In the context of international trade, when a domestic country exports a good, it means the country sells that good to other countries in the global market. This typically occurs when the domestic country has a comparative advantage, meaning its domestic price for the good is lower than the world price (P{\text{domestic}} < P{\text{world}} ), and its domestic quantity supplied exceeds its domestic quantity demanded at the world price.
The Effects of a Tariff
Tariff Defined
A Tariff is a specific type of tax levied on imported goods or services, imposing additional costs on foreign products as they enter the domestic market. Tariffs can be specific (a fixed charge per unit of the imported good) or ad valorem (a fixed percentage of the value of the imported good).
Effects Before Tariff
Initially, under free trade conditions, the domestic price is equivalent to the world price (P{\text{domestic}} = P{\text{world}} ), meaning consumers pay the global market price and imports fill the gap between domestic demand and supply.
Effects After Tariff
Post-tariff, the domestic price rises to equal the world price plus the tariff amount (P{\text{domestic}} = P{\text{world}} + \text{Tariff}} ). This increase in price makes imported goods more expensive for domestic consumers.
The Impact of a Tariff
Implementing a tariff leads to reduced import quantities as the higher domestic price discourages demand and encourages domestic production. This moves the domestic market back towards its without-trade equilibrium, but at a higher price and lower quantity than under free trade.
It results in increased government tax revenue (from collecting the tariff on each imported unit), but simultaneously decreases total surplus due to inefficient allocation of resources, creating a deadweight loss. This loss arises because the tariff prevents some mutually beneficial trades from occurring and diverts production from more efficient foreign producers to less efficient domestic producers.
Figure 4: The Effects of a Tariff
The figure demonstrates the changes in consumer and producer surplus before and after tariff imposition:
Consumer Surplus: Significantly decreases due to the higher domestic price.
Producer Surplus: Increases because domestic producers can sell more goods at a higher price.
Government Revenue: A new area representing the tariff revenue collected by the government (quantity of imports multiplied by the tariff per unit).
Falling Total Surplus: The total surplus decreases, and this reduction is represented by the areas identified as deadweight loss (D + F ). Area D represents the loss from underconsumption (consumers buying less due to higher prices), and area F represents the loss from overproduction by less efficient domestic firms (inefficient resource allocation away from production based on comparative advantage).