Why Nations Trade: A Partial Equilibrium View

1. Why Nations Trade: A Partial Equilibrium View Nothing is accomplished until someone sells something. (popular business saying)

2. The Goals of this Chapter • Introduce a two-country partial equilibrium model of international trade. • Use the partial equilibrium model to illustrate how consumers and producers are affected by international trade. • Use the partial equilibrium model to analyze the effects of exchange rate changes, changes in demand, and transportation costs. • Introduce international marketing and show how it complements comparative advantage by helping to determine the value of products that are traded internationally. • Explain how the need for international marketing introduces a fixed cost to international trade that tends to prevent the smooth adjustments predicted by the standard international trade models.

3. Measuring the Welfare Gains from Exchange:Producer Surplus and Consumer Surplus • Producer surplus: The net gains to producers of a product, equal to the total revenue minus the sum of marginal (variable) costs. • Consumer surplus: The net gains for consumers of a product, equal to the sum of all marginal gains minus the market price paid for the products.

4. Equilibrium price = $6 • Equilibrium quantity = 50

5. Equilibrium price = $65 • Equilibrium quantity = 50 • Producer surplus = $125 ($5x50 = $250/2 = $125)

6. Equilibrium price = $6 • Equilibrium quantity = 50 • Producer surplus = $125 ($5x50/2 = $250/2 = $125) • Consumer surplus = $75 (3x50/2 = $150/2 = $75)

7. Equilibrium price = $6 • Equilibrium quantity = 50 • Producer surplus = ($5x50)/2 = $250/2 = $125 • Consumer surplus = $75 ($3x50)/2 = $150/2 = $75 • Total gains from exchange equals consumer surplus plus producer surplus • Gains from exchange = ($8x50)/2 = $400/2 = $200

8. The Two-Country Partial equilibrium Model • The textbook emphasizes two-country models in order to remind you that what happens in one country affects markets in other countries. • Partial equilibrium models assume “all other things remain equal” in other markets, obviously an unrealistic assumption. • But, a two-country partial equilibrium model can isolate how, all other things equal, a change in a market in one country affects the market for the same product in another country. • Specifically, the two-country partial equilibrium model lets us estimate the changes in consumer and producer surplus in the two countries.

17. The Welfare Gains from Trade • Heartland producers gain surplus. • Heartland consumers lose surplus. • Orient producers lose surplus. • Orient consumers gain surplus. • Worldwide, net welfare gains from trade in corn are the sum of the net gains in Heartland and in Orient.

18. Summarizing the Welfare Gains and Losses in Both Countries • Heartland producers gain B+C = $41.25 • Heartland consumers lose B = –$33.75 • Heartland’s net welfare gain = C = $7.50 • Orient’s producers lose b = –$30.00 • Orient’s consumers gain b+c = $45.00 • Orient’s net welfare gain = c = $15.00

19. Applying the Two-Country Partial Equilibrium Model • Now that you understand the two-country partial equilibrium model and how to calculate the welfare gains from international exchange, you are ready to apply the model. • One interesting case is to examine the welfare effects of an increase in foreign demand for a product. • Specifically, suppose that in a certain market, demand increases in the foreign country that currently imports the good.

23. The Net Gains from Trade Increase in Both Countries after the Rise in Demand in Orient • An increase in foreign demand raises the price of corn in both countries. • Producers in Heartland gain welfare. • Consumers in Orient gain welfare. • The net gains from exchange increase in both countries.

24. Applying the Two-Country Partial Equilibrium Model • Another case, discussed in Case Study 4.2 in the textbook, is to analyze the welfare effects in a given product market after a change in the exchange rate. • Suppose that the exchange rate of $1.00 = 5 euros changes to $1.00 = 8 euros, which constitutes and appreciation of the dollar. • Suppose also that the United States is the exporting country in a certain market.

30. The International Market for Hoses after the Dollar Appreciation • The net gain from trade for Europe declines to the area b. • The volume of The net gain from trade for the United States declines to area a. • trade declines from 0f to 0g. • Overall, in this market the gains from trade decline.

31. Analyzing the Effect of Transport Costs on International Trade • The partial equilibrium model can be used to analyze how transport costs affect international trade. • Transport costs in effect drive a wedge in between the price received by an exporter and the price paid by a foreign importer. • Transport costs increase the cost of products to the final user, and it should not be surprising that they reduce both the volume of trade and the gains from trade. • The analysis of transport costs uses the concepts of consumer and producer surplus.

32. Consumer surplus is equal to the area A • Producer surplus is equal to the area B • The net gains from exchange are equal to the areas A + B

33. Transport costs of $40 raise the effective international supply curve from S to ST. • Transport costs drive a “wedge” between what suppliers receive and consumers pay. • The volume of trade falls from 40 to 20. • Producer surplus is reduced to area b. • Consumer surplus is reduced to area a.

34. Decreasing transport costs increase trade. • The international supply curve shifts down to ST2. • The equilibrium price falls to $60. • The gains from trade rise from a + b to a + b + c + d.

35. Trade and Transport Costs • An increase in transport costs reduces the gains from trade for both the importing and exporting countries. • A decline in transport costs increases the gains from trade. • Most of the increase in trade during the past two centuries is due to improvements in the efficiency of transportation.

36. The Effect of Trade on Price Competition • The partial equilibrium model is also useful for analyzing the gains from trade under imperfect competition. • International trade increases the number of potential suppliers, which tends to increase price competition. • Increased price competition reduces monopoly profit and deadweight losses. • The effect of increased competition can be visualized by comparing consumer and producer surplus under imperfect competition and under perfect competition.

37. Imperfectly competitive firms face a downward-sloping demand curve D. • Profit-maximizing firms equate marginal revenue equal marginal cost. • Prices exceed marginal cost. • The quantity supplied, q, is less than the quantity, Q, that would be supplied under perfect competition. • Total welfare is reduced by the “deadweight” loss, which is equals to area D.

38. When firms face the horizontal demand curve in a competitive global market, price declines from p to P. • Consumption shifts from c to C. • The competitive market eliminates the deadweight loss.

39. International Trade and International Marketing • The term comparative advantage is seldom used by international exporters and importers. • Instead, marketers are concerned about competitive advantage, which refers to a firm’s advantage in providing its customers or potential customers with value. • Value is the net sum of a product’s perceived benefits, such as quality, convenience, and prestige, relative to its price. • Specifically, we define a product’s value, V, as V = B/P, where B and P are the product’s benefits and price, respectively.