Putting it Together: The Gain From Trade (2024)


Now we can put the tools developed in the previous twotopics together to discuss, at a rudimentary level of course,what might be socially optimal. In any discussion of what isor might be good or bad from the point of view of society as awhole, the economist is limited to commenting on issues ofefficiency. Though economists may be able to say somethingabout how a particular policy might affect the distribution ofincome among the members of society, economics provides noinsights on whether a particular distribution of income isgood or bad---this requires value judgements.

Figure 1 can refer to any particular commodity or servicefor which the supply curve slopes upward and the demand curvedownward.

Putting it Together: The Gain From Trade (1)

The free market equilibrium price and quantity areP0 and Q0. We have noted that the total benefit to the purchasers of the good is the area under the demand curve to the left ofQ0---the sum of the areas A , B and C. And the marginal benefit at output Q0 is the distance Q0a. The alternative opportunity cost of producing output Q0 is the area under the supply curve---denoted by C. And the marginal opportunity cost of producing the output Q0 is alsothe distance Q0a. If there are no consumption externalities, the net benefit to society from having the quantity Q0 rather than none at all is the area under the demand curve and over the supply curve---areaA plus area B. The area A is the consumer rent or surplus and the area B is the producer surplus or rent.

The output Q0 in the above Figure would appear to be the socially optimal output in the sense that the gains to the purchasers net of theopportunity costs are maximized. These gains are maximized whenthe marginal social benefit from having another unit of outputequals the marginal social opportunity cost and when the areaunder the demand curve and over the supply curve is therebymaximized. If output were reduced below Q0, some of these net gains would be lost. Losses would also result if output wereexpanded beyond Q0. The marginal opportunity costs of producing output beyond this point would exceed the marginal benefits.

We cannot guarantee, however, that when output is increasedto Q0 from below that level everybody in the society gains the same amount---indeed, normally some people will not gain at all. What can be said is that there is an opportunity for everyone togain. The appropriate division of these potential gains as wellas the final decision to go after them are issues beyond thepurview of economic analysis. But sensible people prefer moreto less if a way can be devised to achieve it, so the economist'sinsights here are of considerable value.

These issues become front and center when we now introducethe possibility that the residents of this country or local areacan purchase and sell the commodity in question on the worldmarket at a fixed price. This world price is given by the thickhorizontal line in Figure 2.

Putting it Together: The Gain From Trade (2)

Starting from the initial quantity Q0, demanders will find it worthwhile to increase the quantity they purchase to Qc. They will pay an amount equal tothe sum of the areas C, G,J and K for thisquantity and their gross benefit will now be the area under thedemand curve to the left of Qc rather than the area to the left of Q0. They will be better off on net because their surplus or rent will increase by an amount equal tothe sum of B, F and H.

Producers will now find that they can no longer sell theiroutput at price P0 and are forced to take the world market price instead. At that price it will be profitable to produce only Qp. Their surplus or rent will fall to the areaC and they will be worse off by the area B. So producers will be against the introduction offoreign competition.

Notice, however, that consumers gain the sum of areas B, F and H while producers lose only area B. There is a net gain to society in thesense that consumers could bribe producers by giving them theamount B and still be better off by the sum of areasF and H.

Notice that people in the area consume output Qc and produce output Qp. The excess of Qc over Qp, is imported from the rest of the world. Domestic consumers now pay the amount C + G to domestic producers and the amount J + K to foreign producers,whereas previously they paid the sum of areas B,C, G, J andF to domestic producers. When we to take into account all goods in the world economy, not just this one, it turns out that the payment toforeigners, J + K, will be matched by equivalent earnings from additional exports of other goods to the rest of the world. Domestic resources are shifted out of production of the importedgood and into the production of other goods that will be exported while domestic purchases are shifted away from those other goods in order to buy more of the imported good.

A similar gain from trade arises when the world price isabove the free market price, as shown in Figure 3.

Putting it Together: The Gain From Trade (3)

In this case production expands and consumption contracts. Producers gainthe area B + L + H and consumers lose the area B + L, witha net gain equal to the area H. The excess of Qp over Qc is exported.

The fact that domestic consumers gain the area B + F + H while domestic producers lose only the area B in Figure 2 and producers gain the area B + L + H while consumers lose only B + L in Figure 3 indicates that there is a gain from trade in the sense that it is possible to go from zero international trade in this commodity to free trade and make everyone better off---all that is necessary is a payment to producers by consumers somewhat in excess of the area B in Figure 2 or a payment to consumers by producers somewhat in excess of B + L in Figure 3. The difficulty is, of course, that such compensating payments are almost never made. The move to free trade therefore benefits part of the community and hurts another part, even though in dollar terms the benefits exceed the hurt.

This means that the losers from free trade will vigorouslyoppose it---resources will be used up trying to convince thegovernment and the public which it represents that free tradein the circ*mstances at hand is bad. Gainers, on the otherhand, will devote resources to demonstrating that free trade isgood. Economists call these activities rent seeking. Theresources spent in political conflict over rents could be usedto produce goods for current consumption or for investment incapital goods that will help produce more future consumption.

Most frequently in the case where imports displace domestic production the losers from free trade are a small group of producers, each of whom stands to lose a significant amount. On the other hand, the gainers consist of many consumers who individually gain very small amounts. The gain might be $550,000 split among one million consumers (amounting to 55cents per consumer) while loss might be $500,000 split among 20 producers (amounting to $25,000 per producer). Producers thus have a strong incentive to form a trade association and take up the fight, while most consumers probably don't even know they gain from trade. The fact that the gain here to individual consumers is too small to be noticeable makes them vulnerable to carefully craftedarguments from producers suggesting that free trade is costly rather than beneficial---a proper evaluation of these arguments is not worth individual consumers' time. As a result, most societies frequently end up not only loosing gains from trade, but wasting additional resources in rent seeking activities designed to convince everybody that free trade produces lossesrather than gains.

The gain from trade is an efficiency argument. Throughfree trade, everyone can have more. If we cannot handle thedistribution effects, however, and really make everyone betteroff, is efficiency worth pursuing?Potential efficiency gains and losses appear all over theeconomy, not just in situations involving free vs. restrictedtrade. Every pursuit of an efficiency gain hurts someone,albeit by less than others gain. If potential efficiency gainsare always pursued, most people will gain on some occasions andlose on others. On average nearly everyone will gain. Thosefew who end up in a clearly losing position can be compensated.

Despite this, it is in every individual person's interestto fight hard to preserve those inefficiencies from which he orshe benefits---in each individual circ*mstance a gain is to behad regardless of what happens to everyone else. Unfortunately, a social contract in which we all agree to permit the unfettered pursuit of economic efficiency, in return for a promise of compensation if we happen to be among the few who end up losing significantly on balance, is impossible to enforce.

It is test-time again. As always think about your answers carefully before looking at the ones provided.

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Putting it Together: The Gain From Trade (2024)
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