Chapter 2
The Basic Theory Using Demand and Supply
Four Questions About Trade
1. Why do countries trade? What is the basis for
trade, especially the product (commodity)
composition?
2. For each country, what are the overall gains (or
losses) from trade?
3. What are the effects of trade on each country’s
economic structure? Production, Consumption.
4. What are the effects of trade on the distribution
of income within each country? Winners,
Losers.
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Demand
• Demand for a product depends on a number of
factors, such as tastes, the price of this product,
the prices of other products, and income.
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Demand Curve
• Shows the quantity that consumers will buy at
each possible market price, other things equal.
• Shows the value that consumers place on units of
the product, because it indicates the highest price
that some consumer is willing to pay for each
unit.
• A change in one of the other drivers of quantity
demanded for a product (tastes, the prices of
other products, or income) causes a shift in the
demand curve.
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Demand Responsiveness
How responsive is quantity demanded to a
change in price?
• A measure of responsiveness that is “unitfree” is elasticity, which measures the percent
change in one variable resulting from a 1
percent change in another variable.
• The price elasticity of demand is the percent
change in quantity demanded resulting from a
1 percent increase in price.
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Consumer Surplus
Consumer surplus is the increase in the
economic well-being of consumers who are able
to buy the product at a market price lower than
the highest price that they are willing and able
to pay for the product.
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Supply
What determines how much of a product is supplied by
a business firm (or other producer) into a market?
• A firm supplies the product because it is trying to
earn a profit on its production and sales activities.
• One influence on how much a firm supplies is the
price that the firm receives for its sales.
• The other major influence is the cost of producing
and selling the product.
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Supply Curve
• Shows the quantity that producers will offer
for sale at each possible market price, other
things equal.
• Shows the marginal cost of producing units of
the product.
• A change in one of the other drivers of
quantity supplied for a product (prices and
availability of inputs, technology, or number
of firms) causes a shift in the supply curve.
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Producer Surplus
Producer surplus is the increase in the economic wellbeing of producers who are able to sell the product at a
market price higher than the lowest price that would
have drawn out their supply.
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Supply Responsiveness
Price elasticity of supply measures the percent
increase in quantity supplied resulting from a 1
percent increase in market price.
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Demand and Supply for Motorbikes
Qd = a – b P Qd = 90,000 – 25 P or in inverse form: P = 3,600 – 0.04 Qd
Qs = c + d P QS =-10,000 + 25P or in inverse form: P = 400 + 0.04 Q
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The Market for Motorbikes: Demand
and Supply
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Two National Markets and the
Opening of Trade
Arbitrage is buying something in one market
and reselling the same thing in another market
to profit from a price difference.
With no trade, differences in the price of a
product between national markets creates an
arbitrage opportunity that can lead to
international trade.
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Free Trade Equilibrium
As international trade in a product (e.g., motorbikes) develop
between the two countries, it affects the equilibrium price in
importing and exporting countries.
• If there are no transport costs or other frictions, free trade
results in the new countries having the same price for
motorbikes. We call this free-trade equilibrium price the
international price or world price.
• Demand for imports is the excess demand (quantity
demanded minus quantity supplied) of a good within the US
national market.
• Supply of exports is the excess supply (quantity supplied
minus quantity demanded) of a good in the rest-of-the-world
market.
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The Effects of Trade on Production, Consumption, and
Price with Demand and Supply Curves
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The Effects of Trade on Well- Being of Producers,
Consumers, and the Nation as a Whole
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Welfare Effects of Free Trade
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Effects in the Importing Country
• The shift from no trade (autarky) to free trade
lowers the market price.
• The decrease in price will benefit consumers(a
welfare gain) by a net amount of a + b + d
• The decrease in price will reduce producer
surplus by area a
• The net gain from free trade for the United
States as whole is
• Net Gain for the U.S. = (a + b + d) – a = b + d
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Effects in the Exporting Country
• The shift from no trade (autarky) to free trade raises
the market price.
• The increase in price benefits producers in the rest of
the world, whose producer surplus increases by area
j + k + n in Figure 2.4
• The increase in price hurts consumers, whose
consumer surplus decreases by area j + k .
• Using the one-dollar, one-vote metric, we can say
that the exporting country gains from trade, and that
its net gain from trade equals area n .
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Which Country Gains More?
• This analysis shows that each country gains from international
trade, so it is clear that the whole world gains from trade. Trade is a
positive-sum activity.
• The gains from opening trade are divided in direct proportion to the
price changes that trade brings to the two sides. If a nation’s price
changes x percent (as a percentage of the free-trade price) and the
price in the rest of the world changes y percent, then
𝑁𝑎𝑡𝑖𝑜𝑛′ 𝑠 𝑔𝑎𝑖𝑛
𝑅𝑒𝑠𝑡 𝑜𝑓 𝑤𝑜𝑟𝑙𝑑 ′ 𝑠 𝑔𝑎𝑖𝑛
=
𝑥
𝑦
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Which Country Gains More?
• The side with the less elastic (steeper) trade
curve (import demand curve or export supply
curve) gains more.
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