The Gains from Trade: A General Equilibrium View Between a good and a bad economist this constitutes the whole difference–the one takes account of the visible effect; the other takes account of both of the effects which are seen, and also of those which it is necessary to foresee. (Frédéric Bastiat)

The Goals of this Chapter Introduce the general equilibrium model of international trade, first in its “small country” version and then in its “two-country” version. Use the small country model to make it very clear that imports and exports are closely related; reducing imports inevitably causes a reduction in exports. Use the two-country model to show how trade affects both the domestic and foreign economies by shifting output and consumption and raising real output and income in both countries. Show how increasing returns to scale provide a second source of potential gains from trade.

The Example of the Nebraska Auto Industry International trade reduces the opportunity costs of indirectly producing importable products. The general equilibrium model of this chapter will show that protecting import-competing industries reduces production in export industries. The model makes it clear that trade restrictions are not an issue of favoring domestic interests over foreign interests, but an issue of favoring some domestic interests over other domestic interests.

The “Small-Country” General Equilibrium Model The small-country model assumes that the actions of its citizens have no noticeable effects on foreign prices or the quantities produced by foreign industries. The model’s general equilibrium nature means that it traces the effects of an economic change to all sectors of the domestic economy. To enable us to use two-dimensional diagrams, the model assumes that there are just two industries in the economy. The model uses a production possibilities frontier to represent the supply side of the economy. It uses indifference curves to represent consumer preferences and the demand side of the economy.

The Small-Country General Equilibrium Model The model uses a production possibilities frontier (PPF) to represent the supply side of the economy The PPF is “bowed out” to reflect increasing costs The PPF tells us how much of one good we must sacrifice in order to make available the resources to produce one more of the other good

The Small-Country General Equilibrium Model A closed economy must produce and consume at points located on or below the PPF. The points B, C, and D are all attainable. Note that the point D implies that not all available resources and technology are being exploited. The point A outside the PPF is not feasible.

The Small-Country General Equilibrium Model The welfare-maximizing production/consumption combination is at the point where the PPF and the indifference curves have the same slope. The tangency between the PPF and the indifference curve at A is the point where the opportunity costs of producing food and clothing are equal to the relative marginal benefits from consuming food and clothing.

The Gains from Trade If the world price ratio is different from the domestic price ratio p, an open economy can use foreign trade to reach consumption points outside its PPF. The diagram shows the consumption possibilities line (CPL) whose slope reflects the world price ratio. A small open economy that continues to produce at A can consume anywhere along the CPL.

The Gains from Trade Given the bundle of food and clothing produced at A, welfare maximization will take consumers to point B, the tangency between the indifference curve and the CPL. At B, the relative marginal gains from consuming food and clothing are equal to the world price ratio. The trade triangle connects points A and B.

The Gains from Trade An open economy can achieve further gains from trade by specializing. By shifting production from A to P, a higher CPL can be reached. Given production and income generated at P, consumers choose to consume at point C.

The Gains from Trade The combination of exchange and specialization takes the country to a higher welfare level. Compare the smaller exchange-only trade triangle connecting points A and B with the trade and specialization trade triangle connecting points P and C. With exchange and specialization, a higher indifference curve comes within reach.

Summarizing the Results of the Simple Two-Good Model When relative prices (opportunity costs) of goods are not the same at home and abroad, countries can increase national welfare by engaging in international trade. The gains from exchange are the result of domestic consumers substituting the relatively cheaper foreign products for the relatively more expensive domestic products. The gains from specialization are the gains from shifting domestic resources away from producing products that are relatively cheaper overseas to those products that are relatively more expensive overseas.

An economy can enjoy the gains from exchange without specializing, but it cannot enjoy the gains from specialization without trading. Merely shifting production to P only reduces welfare, s evidenced by the lower indifference curve passing through P. It takes exchange to get to C and the higher indifference curve. There Are No Gains from Specialization Without Exchange

Trade and Growth Achieve Similar Gains in Welfare Trade and growth both enable the economy to reach a higher indifference curve. Trade leads to a new consumption point at C. Growth leads to a new consumption point at D. Both points lie on the same indifference curve.

The Two-Country General Equilibrium Model The small-country model can only tell us how one country is affected by international trade. The assumes that there are no effects on the rest of the world. In general, international trade generally causes changes in prices and shifts in resources both at home and abroad. We therefore develop a two-country general equilibrium model that explains trade between two countries and describes the many changes that occur in both countries as a result of the opening up of trade.

The 2-Country General Equilibrium Model The two-country model shows that both countries gain from trade; each reaches a higher indifference curve. Each country specializes in producing products for which it has the lower opportunity costs. One country’s exports are the other’s imports. Relative prices are equalized across both countries.

The Principle of Comparative Advantage Comparative advantage reflects the opportunity costs of production of food and clothing in each economy as given by the PPFs at their self-sufficiency equilibria. Each country reaches a higher level of welfare by specializing in, and exporting, the good that has the lower opportunity cost. The two-country, two-product general equilibrium model illustrates comparative advantage because it shows that each country exports the product for which it has the lower opportunity costs. Comparative advantage also implies that trade is welfare enhancing for both countries.

Opportunity Costs In the textbook example, the prices of food relative to clothing are equal to 2 in Homeland and ½ in Abroad. This implies the following opportunity costs: Homeland:Abroad: Food: ½ piece of clothing2 pieces of clothing Clothing: 2 pounds of food ½ pound of food Homeland therefore has a comparative advantage in food, Abroad has a comparative advantage in clothing

Variations of the Model The two-country general equilibrium model shown above assumed PPF’s differed across the two countries, which caused relative prices to differ. Relative prices. (opportunity costs) can also differ when preferences differ. When indifference curves vary, closed economy price ratios differ even for the same PPF: p* > p

Variations of the Model If free trade equalizes prices across both countries, each country produces at point P but consumes at different points, C and C*. Each country will consume more of the product it “prefers,” exporting the other product in order to acquire more of the product it prefers.

The General Equilibrium Model Does Not Explain All Trade The two-country general equilibrium model predicts that countries trade more if their PPF’s and opportunity costs differ a lot. Thus, dissimilar countries should trade more than countries that have similar productive capacities and tastes. This is not what we observe in the world, however!

Most Trade Is Between Highly-Developed Economies Most trade occurs among similar high-income economies. Only about one-third of the world’s trade occurs between economies with very different productive capacities. Of course, countries with similar income levels are not identical, but their relative opportunity costs are no doubt more similar than for pairs of countries at very different levels of development.

Alternative Models of Trade Economists have developed alternative models to explain trade that does not seem to be driven purely by differences in economic capacity and consumer preferences. One of the most useful is the model that assumes production is subject to decreasing costs rather than increasing costs, as the two-country general equilibrium model assumed. In this case, the PPF is bowed inward rather than outward; that is, opportunity costs decrease the higher the level of production in an industry.

Figure 3.14 The PPF with Increasing Returns

Increasing Returns to Scale and Trade Increasing returns to scale imply that prices will be lower when industries produce large quantities of similar products. Consumers do like variety, as suggested by the bowed-in indifference curves. Consumers can gain better trade-off between costs and variety if countries trade freely. In the case of increasing returns, trade raises human welfare in each country even though both countries are identical.