Chapter 14 · International trade: Part I
Free trade and welfare
Show the effects of free trade on consumer surplus and producer surplus. Compare domestic equilibrium with trade at a given world price.
The economic idea
International trade is the exchange of goods and services across national borders. Exports are produced domestically and sold abroad; imports are produced abroad and purchased domestically.
Free trade means international exchange without protectionist barriers such as tariffs, quotas or discriminatory subsidies. It does not mean trade is costless: transport, insurance, information and regulatory costs may remain.
Autarky is a situation without international trade, so domestic quantity demanded must equal domestic quantity supplied at the domestic equilibrium price. Opening to trade exposes the market to the world price.
The small-country assumption means domestic purchases or sales are too small to influence the world price. World supply is therefore represented as perfectly elastic by a horizontal line.
Gains from trade arise when exchange replaces higher-opportunity-cost domestic activity or enables additional mutually beneficial consumption. The national surplus result is distinct from the distribution of those gains among consumers, producers, workers and regions.
Reading domestic demand and supply at Pworld
“Quantity” is measured horizontally and “Price” vertically.
“D domestic” and “S domestic” describe the domestic market; “Pworld” is the externally given price available to this small economy.
“A” identifies domestic supply “Qs₁” at “Pw”, while “B” identifies domestic demand “Qd₁” at the same price.
Autarky is the comparison, not a second market
Without trade, “D domestic” and “S domestic” determine one domestic price where production equals consumption. That intersection is the benchmark even when it is not separately labelled on the current graph.
Opening the market at Pw
“Pworld” lies below the autarky equilibrium price. At “Pw”, domestic consumption “Qd₁” exceeds domestic production “Qs₁”, so imports equal the horizontal distance from “A” to “B”.
Separate redistribution from the net gain
Relative to autarky, the lower price expands consumer surplus and reduces producer surplus. The consumer gain exceeds the producer loss under the small-country assumptions, creating production and consumption gains from trade.
Locate consumer and producer surplus at the world price
To identify consumer surplus, look below “D domestic” and above “Pw”, up to domestic consumption “Qd₁”. Producer surplus lies above “S domestic” and below “Pw”, up to domestic production “Qs₁”. Do not extend domestic producer surplus over imported units.
Compare the total of those two areas with autarky. A transfer from one domestic group to another cancels in that total; the net gain comes from cheaper production or additional consumption made possible by trade.
From a closed market to the current open-market outcome
Locate the domestic autarky equilibrium where “D domestic” intersects “S domestic”.
Compare “Pworld” with that price and read “Qs₁” and “Qd₁” at “Pw”.
Common mistakes to avoid
- “Pworld” does not shift domestic demand or supply; it selects quantities along the existing curves.
- Imports are not domestic consumption alone; they are domestic consumption minus domestic production.
- Exports are not domestic production alone; they are domestic production minus domestic consumption.
- A national gain from trade does not mean every domestic stakeholder gains.
- The horizontal world-price line depends on the small-country assumption and should not be applied mechanically to a country with market power.
How to draw this diagram
- Title the diagram “Free trade and welfare”. Label the horizontal axis “Quantity” and the vertical axis “Price”.
- Draw D domestic first and label it clearly.
- Draw S domestic next and label it clearly.
- Draw Sworld (Pw) next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Add the relevant guide lines and shade the economic area only after its boundaries are established.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The country is assumed too small to affect the world price and able to trade any quantity at that price.
- Transport, insurance, border delays, exchange-rate movements and product-quality differences are omitted.
- The model is static and does not show unemployment, retraining, investment, innovation or long-run structural change.
- External costs and benefits, market power and supply-chain risks can alter the national welfare result.
- Total surplus does not reveal how gains and losses are distributed among households, firms, workers and regions.