Comprehensive Study Notes on Small Economy Assumption and Free Trade Dynamics

Small Economy Assumption

  • Definition: The small economy assumption posits that the domestic country can open its borders to free trade without influencing the world price. This implies that the domestic price will always adapt to the world price (PW).
  • Key Implication: Under free trade, a domestic economy acts as a price taker and therefore accepts the world price as given.

Price Adjustments in Free Trade

  • The price in the domestic market adjusts to PW, which affects exports significantly.
  • Profit Maximization Scenario:
    • If a business can sell its products (e.g., cheese) at a higher price in a foreign market (like France), it would maximize profits by selling there rather than keeping prices lower for domestic consumers.
    • This results in all domestic consumers paying the world price, further implying a profit incentive.

Graphical Representation

  • Description of Domestic Market:
    • Domestic Demand Curve: Represents the demand in the domestic market.
    • Domestic Supply Curve: Represents the supply in the domestic market.
    • Domestic Price (PD): The equilibrium price before trade.
    • Quantity at Domestic Equilibrium (Q1): The quantity supplied or demanded at the domestic price before trade begins.
  • Impact of Free Trade:
    • World Price (PW): Establishes a new higher price leading to increased exports and alters consumer surplus and producer surplus.

Consumer Surplus and Producer Surplus

  • Change in Consumer Surplus:
    • Consumer surplus, defined as the area above PW and below the demand curve, experiences a decrease (shown as areas C and D).
  • Change in Producer Surplus:
    • Producer surplus, which is the area below the price and above the supply up to the quantity sold, increases significantly.
    • New producer surplus area comprises areas A, B, plus additional areas C, D, and F, evidencing an overall gain for producers.

Resource Allocation and Employment Effects

  • Impact of Increased Production:
    • With the transition to free trade, producers increase output, necessitating more resources and leading to job creation in associated industries.
    • Example: Resources such as labor may see increased demand as production expands, enhancing overall economic well-being.

Import Scenarios and Economic Implications

  • Tax Impact on Buyers and Sellers:
    • When a tax is implemented on buyers or sellers, market dynamics distort: prices increase for consumers, leading to lower quantities sold.
  • Graphical Representation of Free Trade Import Dynamics:
    • With imports at price PW represented by quantities Q2 and demand at Qb3.
    • Tariff Scenario: Introduces a tax (T) on imports, increasing the price to VW + T, with new quantities represented as Qs3 and Qb3.

Tariff Effects

  • Legal Payment of Tariff:
    • Legally paid by the firm importing goods, yet economically, consumers bear the burden of the tax through higher prices.
  • New Economic Dynamics Caused by Tariffs:
    • Producer surplus changes as tariffs reduce overall available consumer surplus, potentially leading to decreased imports and increased domestic prices.
  • Overall Economic Assessment:
    • Use concepts of comparative advantage to understand why some goods are imported and potential losses in consumer surplus.

Comparative Advantage and Market Dynamics

  • Comparative Advantage Explanation:
    • Reflects scenarios where a country does not have the efficiency to produce certain goods (like cheese) compared to others, often due to lack of resources, technology, or skilled labor.
  • Free Trade Argument:
    • The premise is that even if one product is not efficiently produced domestically, benefits exist from specializing in what is produced best.

Government Protection Arguments

  • Protection Debate:
    • Employment Arguments: Attracting government protection on the basis of job preservation.
    • Tariff Examples:
    • Softwood Lumber Industry: Showcased with a 12% tariff resulting in minimal job protection (80 jobs) vs. consumer surplus losses.
    • Financial Dilemma: Cost per job saved in protected industries can reflect wasteful economic policy decisions.

Tariff and Trade Retaliation Dynamics

  • Historical Context and Retaliation Effects:
    • Example of US chicken exports to Europe post-World War II, illustrating complex retaliatory measures taken by governments.
    • Retaliatory Measures: Illustrated by taxes on various imported products as forms of economic leverage.
  • Producer Effects: Tariffs can inflate production costs, leading to potential relocations or closures of businesses, decreasing domestic market competition.

Calculating Trade Quantities

  • Quantity Calculation Methodology:
    • Always utilize the larger quantity minus the smaller quantity to maintain positive values when calculating imports and exports.
  • Calculating Demand and Supply from Price adjustments:
    • Strategies in determining quantity demanded and supplied from adjusted market prices (e.g., moving from $4 to a new price of $8).