chapter 2 the basic theory using demand and supply

Chapter 2The Basic Theory Using Demand and Supply

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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.


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.


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.


Demand Responsiveness

How responsive is quantity demanded to a change in price?• A measure of responsiveness that is “unit-

free” 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.


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.


SupplyWhat 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.


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.


Producer Surplus

Producer surplus is the increase in the economic well-being 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.


Supply Responsiveness

Price elasticity of supply measures the percent increase in quantity supplied resulting from a 1 percent increase in market price.


Demand and Supply for MotorbikesQd = 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


The Market for Motorbikes: Demand and Supply


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.


Free Trade EquilibriumAs 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.


The Effects of Trade on Production, Consumption, and Price with Demand and Supply Curves


The Effects of Trade on Well- Being of Producers, Consumers, and the Nation as a Whole


Welfare Effects of Free Trade


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


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 .


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

=


Which Country Gains More?

• The side with the less elastic (steeper) trade curve (import demand curve or export supply curve) gains more.

chapter 2 the basic theory using demand and supply

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