International Trade Theory and Policy
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International Trade Theory and Policy
By Amjad Khan, Ph.D.
Division of Business
Oklahoma City Community College
International Trade Theory
International trade is based on the existence of excess demand and excess supply of commodities among nations. Excess demand for a certain commodity in a country is the gap between the domestic supply and domestic demand of the commodity in question. To meet the gap, the country imports the commodity from another country where the domestic supply exceeds the domestic demand for that commodity. The price of the commodity should be lower in the exporting country compared to the importing country. The concepts of international trade, the welfare analysis of trade, and the consequences of the trade distortion policies are presented in following sections.

The Theory of Comparative Advantage

A conceptual model of the law of comparative advantage and gains from trade is shown on page 1 of album 1 (Tweeten, 1979). The model includes two countries, the U.S. and Brazil, and two agricultural commodities, wheat and sugar. Given the farm resources, the two countries will produce a combination of wheat and sugar along their production possibility frontier curves P. In the diagram, I0 and I1 represent the indifference curves of the two countries. In the absence of external trade, given their national endowment, the highest indifference curve that each country can reach is I0 and the tangency of I0 to the production possibility frontier curve in each country, point A, represents the production and consumption of the combination of wheat and sugar. In other words, at point A the marginal rate of substitution in consumption is equal to the marginal rate of transformation in production or the slope of I0 is equal to the slope of P. The slope of the line T0 indicates the equilibrium price ratio of both commodities in each country. With the assumption of full employment of all available resources in each country, the line T0 measures the foregone units of sugar in order to produce one additional unit of wheat. The slop of T0 (in the absence of a trade scenario) is steeper for the U.S. compared to Brazil. This means that in the U.S. the price of sugar is higher than the price of wheat. The opposite is true for Brazil: the flatter slope of the price line in Brazil shows that the price of wheat is higher than the price of sugar as compared to the U.S.
The relatively higher price of sugar in the U.S. and wheat in Brazil are the result of differences in their production capabilities rather than consumer preferences. The United States has a comparative advantage in wheat production and Brazil has a comparative advantage in the production of sugar, although the U.S. can produce both wheat and sugar at a lower cost than Brazil. Also, if the U.S. can produce wheat, sugar or both at a total lower cost compared to all other countries in the world then the U.S. is said to have an absolute advantage in the production of wheat and sugar. Both the U.S. and Brazil can still benefit from trade even if the U.S. or Brazil have an absolute advantage in the production of these commodities. The absolute advantage theory can be true for any country and any commodity in the world. However, only comparative advantage is necessary for an economy in order to gain benefits from international trade.
As shown in the diagram with international trade, the societal indifference curves of both countries move to higher levels (from I0 to I1). Both countries will produce at point M where the new trading price line T1 is tangent to the production possibility curve. Consumption will take place at point U in both countries where T1 is tangent to I1. This situation represents a pareto optimum because the same price line is tangent to the production transformation curve (representing an equal marginal rate of transformation in production) and an indifference curve (equal marginal rate of substitution in consumption). As shown in the diagram, the U.S. produces Wp and consumes Wu of wheat. The difference between the two quantities (Wp-Wu) is the net export from the U.S. and a net import into Brazil. Similarly, the difference between the quantity of sugar produced and consumed in Brazil (Sp-Su) is the net export from Brazil and net import to the United States.
Comparative advantage and trade lead to a greater specialization in the production of wheat in the U.S. and sugar in Brazil and higher indifference curves for both countries which means comparative advantage and trade benefit both countries. Although the prices of both commodities in both countries are assumed to be the same in this analysis, in reality, however, prices vary from country to country because of transportation costs and institutional barriers imposed on trade such as quotas, tariffs, subsidies, and domestic price supports. This variation in prices results in the rejection of the theory of comparative advantage that is based only on relative production costs. Since the variation in prices across nations is generally observed, comparative profits rather than comparative advantage is a more complete concept to be the basis for international trade. In application, where the reality of distortionary government policies exists, this modern theory is particularly important. The theory of comparative profits includes production possibilities, consumer preferences, and trade barriers among nations in a real world situation. Hence, a country will have a comparative advantage in exporting a commodity if it receives the highest return per unit of fixed resources in a real world situation.

Welfare Analysis of trade

The welfare analysis of trade is explained in a partial equilibrium model on page 2 of album 1. In order to simplify the presentation of the theoretical framework, a one commodity two country trading scenario is assumed. Homogeneity and competitive conditions in both countries are also assumed. The transfer cost and trade barriers are ignored. The three-panel diagram explains the welfare impact of trade on exporting country A and importing country B. The central figure represents the world market W. As seen in the diagram, in the absence of trade, country A produces QA of wheat at a price of PA. The quantity and the price of the same commodity in country B are, respectively, QB and PB.
In the presence of trade, excess supply EX from exporting country (the quantity that exceeds the exporting country's domestic demand) and the excess demand ED of the importing country (the quantity demanded in excess of domestic supply in importing country) and the international price are shown in the world market . The international price PW and the traded volume QW are determined at the point where the ED curve intersects the ES curve. The international price (which is higher than the exporting country's domestic price before trade and lower than the importing country's domestic price prior to trade) leads to more production and less consumption in the exporting country and more consumption and less domestic production in the importing country. As a result of trade consumers in the exporting country lose and producers gain; however, the gain in the producer surplus more than offsets the loss in consumer surplus by the area X shown in figure A. Further, in the importing country, producers are worse off and consumers are better off but the gain in consumer surplus more than offsets the loss in producer surplus by the area Y shown in figure B. Trade yields a net gain to both exporting and importing countries.
A similar three-panel diagram that includes the analysis of the transportation cost and trade barriers is presented in Tweeten (1979) and Henneberry and Henneberry (1989) which also shows that both trading partners enjoy net gains from trade. The one commodity two country model may be expanded to include more participants by simply adding the excess supply and excess demand schedules of additional exporters and importers. The addition of more countries to the model will reduce the slopes of the world excess supply and excess demand functions, however.

Impacts of Domestic Trade Policies

In the material presented above, no trade barriers among countries were considered. That is, an assumption of no government interventions such as tax, subsidy, and/or quota in the process of international trade was implicit. In reality, however, governments do formulate and implement domestic policies in order to improve producer, consumer, and/or social welfare. For example, the adoption of an import tax, import quota, and export subsidy can lead to an increase in producer welfare. On the other hand, policies such as an export tax, export quota, and import subsidy can result in increased consumer welfare. The graphical analysis of domestic policies are presented by Henneberry and Henneberry (1989) with the distinction of large and small countries. Large and small reflect the relative size or market share (for a commodity analyzed) of a country in the world market rather than the geographic size, population, or national income of that country

Large versus Small Countries

The relative volume of imports and/or exports of a small country compared to a large country is not significant enough to affect through its policies the world price of the commodity for which the country is classified. To the contrary, a large country through its implemented policies do effect the world price of the commodity for which the country is classified. Therefore, it is important to distinguish the impacts of a large and small country on domestic and international markets. A specific country may be classified as a large country with respect to one commodity and small in terms of another commodity because large and small refer to specific commodities. Also, a country that is categorized as a large country in some years may be classified as a small country in others because the level of production of commodities varies over time as well as across geographic regions.
The assumptions of this analysis include a constant marginal utility of money among all producers, consumers, and the government: a one dollar gain to producers exactly offsets a one dollar loss to consumers and/or the government and vice-versa. The world price prevails across all nations until after the adoption of certain policies by one or more countries which yield a difference between the world and domestic prices. It is also assumed that imported goods are perfect substitutes for domestically produced goods. The graphic analyses of import/export tax, quota, and subsidy regarding small and large country cases are presented as follows:

Import Tax: small country
On page 1 (album 2), PW is the world price which is directly translated into domestic price and faced by domestic producers and consumers before the imposition of an import tax (tariff) T on the commodity by a small country. D and S are domestic demand and domestic supply, respectively. After the tariff, the new price faced by producers and consumers increases from PW to PW + T and imports decline from Q/1-Q1 to Q/2-Q2.
The welfare analysis of the small country (after tariff is imposed):
Consumer surplus loss: - a - b - c -d
Producer surplus gain: + a
Government revenue gain: + a
Net social welfare loss: - b - d
Import Tax: large country
On page 2 (album2), PW is the world price, which is faced by domestic producers and consumers of the large country. D and S are domestic demand and domestic supply. When the country imposes tariff T on the commodity, imports to this country decreases from Q/1-Q1 to Q/2-Q2. Since this is a large country the reduction in the imported quantity yields a decreased world demand which leads to a reduced world price (from PW to P/W). The new lower price (after tariff) faced by domestic producers and consumers is (P/W + T).
The welfare analysis of the large country (after tariff is imposed):
Consumer surplus loss: - a - b - c - d
Producer surplus gain: + a
Government revenue gain: + c + e
Net social welfare loss or gain: + e - b - d
When e > b + d the country gains from imposing tariff on the commodity and loses when e < b + d. The tariff that maximizes the area e - (b+d) is the optimum tariff.

The summary of an import tax for both the small and large country cases is as follows:
This policy is formulated to improve producer welfare in the country because with the imposition of an import tax, the quantity of imports is decreased which results in a increased domestic production and decreased domestic consumption. The imposition of a tariff in the small country case always leads to a net social welfare loss. The large country, however, may face a net social welfare loss or gain.

Export Tax: small country
On page 3 (album 2), PW is the price before the export tax is implemented by the Small country. After the export tax, the price reduces from PW to PW - T. Q/1-Q1 is the quantity exported before the export tax is enforced. After the export tax, reduced price results in decreased export quantity from Q/1-Q1 to Q/2-Q2.
The welfare analysis of the Small Country (after the export tax is imposed):
Consumer surplus gain: + a + b
Producer surplus loss: - a - b - c - d - e
Government revenue gain: + d
Net social welfare loss or gain: - c - e

Export Tax: large country
Page 4 (album 2), PW is the world price which is also faced by domestic producers and consumers before the export tax is adopted by the large country. After the export tax, the world price rises from PW to P/W. Exports from the large country decreases which results in a reduced world supply because of the size of the country in the world market (large country) and reduced world supply results in higher world price. Domestic producers and consumers, on the other hand face a lower price than the world price (both before and after the tax) as exports are decreased from Q/1-Q1 to Q/2-Q2. The welfare analysis of the large country (after the export tax is imposed):
Consumer surplus gain: + a + b
Producer surplus loss: - a - b - c - d - e
Government revenue gain: + f + d
Net social welfare loss or gain: + f - (c + e)
If f > c + e, the large country gains. If f < c + e, the large country loses. The optimum tax would be the tax that maximizes the area f - (c + e).

To summarize the consequences of the export tax policy, this policy is designed to improve consumer welfare in the country because with the export tax, the export quantity decreases which results in more quantity available to buy and the availability of more quantity also leads to lower prices. After an export tax is imposed, the small country always faces a net social welfare loss. On the other hand, the large country may face a net social welfare loss or gain. Nonetheless, the world as a whole is worse off because the net welfare gain to the large country (that imposes the export tax) is more than offset by welfare losses in other countries.

Import Subsidy: small country
On page 5 (album 2), PW is the world price faced by domestic producers and consumers before the policy of subsidy is adopted by the small country. After the subsidy, imports increase from Q/1-Q1 to Q/2-Q2. P/W - S is the new lower price faced by domestic producers and consumers.
The welfare analysis of the small country (after placing a subsidy on the commodity):
Consumer surplus gain: + a + b + c + d + e
Producer surplus loss: - a - b
Government revenue loss: - b - c - d - e - f
Net social welfare loss or gain: - b - f

Import Subsidy: large country
On page 6 (album 2), PW is the world price before the subsidy is granted by the large country. P/W is the new price as a result of an import subsidy. P/W is higher than PW because as the large country grants subsidy, the large country's imports increase from Q/1-Q1 to Q/2-Q2 which results in increased demand in the world market. The increased world demand drives the price to increase from PW to P/W. Finally, the price faced by domestic producers and consumers in the large country is P/W - S.
The welfare analysis of the large country (after the subsidy is granted):
Consumer surplus gain: + a + b + c + d + e
Producer surplus loss: - b - c
Government revenue loss: - b -c - d - e - f - h - i - j
Net social welfare loss: -b - f - h - i - j

The summary of the policy of an Import Subsidy is as follows:
Import subsidy leads to decreased prices and increased quantity imported which results in a net social welfare loss in the case of both the small country and the large country.

Export Subsidy: small country
On page 7 (album 2), PW demonstrate the world as well as domestic price Pd. An export subsidy placed by the small country results in a higher domestic price from Pd to P/d which further results in an increase in exports from Q/1-Q1 to Q/2-Q2. Domestic producers increase production from Q/1 to Q/2 and domestic consumers decrease consumption from Q1 to Q2. The welfare analysis of the small country (after the export subsidy is granted):
Consumer surplus loss: - a - b
Producer surplus gain: + a + b + c + d + e
Government revenue loss: -b - c - d - e - f
Net social welfare loss: - b - f

Export Subsidy: large country
On page 8 (album 2), the world price and domestic price are the same before the policy of an export subsidy is adopted by the large country (PW = Pd). After the export subsidy, the country's exports increase from Q/1-Q1 to Q/2-Q2 and since this is a large country, an increase in its exports result in an increase in the world supply which leads to a lower world price from PW to P/W. The price faced by domestic producers and consumers, after a subsidy is granted, is P/d. The welfare analysis of the large country (after an export subsidy policy is adopted):
Consumer surplus loss: - a - b
Producer surplus gain: + a + b + c
Government revenue loss: - b - c - d - f - g - h - i - j
Net social welfare loss: - b - d - f - g - h - i - j

The summary of the above policy follows:
The export subsidy policy is formulated to benefit producers by higher prices received and higher quantity exported. Both small and large countries suffer a net social welfare loss with the adoption of this policy.

Import Quota: small country
On page 9 (album 2), the world price PW and domestic price Pd are the same before the quota is imposed by the small country. The supply curve is represented by SS. After the quota, P/d is the domestic price and SYZS/ is the supply curve faced by domestic producers and consumers. The quantity of the imported quota is Q2-Q1. After the imposition of a quota, domestic price increases from Pd to P/d and domestic production increases from Q1 to Q1 + Q3 - Q2. The welfare analysis of the small country (after placing an import quota):
Consumer surplus loss: - a - b - c - d
Producer surplus gain: + a
Government revenue gain: + b
Net social welfare loss: - c - d

Import quota: large country
On page 10 (album 2), the world price PW is the same as domestic price Pd. After an import quota of Q2-Q1 is imposed by the large country, the world demand declines which results in a decreased world price from PW to P/W. Further, with quota, the supply in the large country declines which causes an increase in the domestic price from Pd to P/d, the equilibrium point on the demand curve and the new supply curve SYZS/.
The welfare analysis of the large country (after placing an import quota):
Consumer surplus loss: - a - b - c - d
Producer surplus gain: + a
Government revenue gain: + b + c
Net social welfare loss or gain: + e - (c + d)
When e > (c + d), the country enjoys a net social welfare gain and suffers a net social welfare loss when e < (c + d). The optimum level of an import quota level would be the level where the area e - (c + d) is maximized.

The summary of the policy: Import quota policy results in an increased welfare to domestic producers. This policy always results in a net social welfare loss when adopted by the small country. In the large country case, however, this policy can lead to a net social welfare gain or loss.

Export Quota: small country:
On page 11 (album2), the world price is the same as the domestic price before the export quota is imposed, PW =Pd. After adopting the policy of the export quota of Q2-Q1, domestic price decreases from Pd to P/d because of an excess supply in the country. Domestic consumption increases from Q1 to Q1 + Q3 - Q2, the point where the new demand curve DYZD/ intersects the supply curve S. The welfare analysis of the small country (after placing an export quota):
Consumer surplus gain: + a + b
Producer surplus loss: - a - b - c - d - e
Government revenue gain: + b + c
Net social welfare loss: - e (since b = d)

Export Quota: large country
On page 12 (album 2), before the large country imposes an export quota, the price faced by domestic producers and consumers is the same as the world price, Pd = PW. DD represents domestic demand and S demonstrates domestic supply. After the quota of Q2 - Q1 is implemented, the world price increases from PW to P/W. Domestic price decreases from Pd to P/d because of an excess domestic supply that resulted from the reduction in exports. The new demand cure is represented by DYZD/. The welfare analysis of the large country (after an export quota is placed):
Consumer surplus gain: + f + g
Producer surplus loss: - f - g - h - i - j
Government revenue gain: + b + c + g + h
Net social welfare gain or loss: + b + c + g - i - j
Since g = i, the net social welfare gain or loss: (b + c) - j
The country enjoys a net social welfare gain if b + c > j and loss if b + c < j
The optimum export quota level would be the one at which the area (b + c) - j is maximized.

Summary of the policy: Export quota policy leads to increased consumer welfare. By adopting this policy, the small country always suffer net social welfare losses whereas the large country may face a net social welfare loss or gain.

In this interactive tutorial the analysis of classical international trade theory and the consequences of deviations from this theory were rigorously explained in separate sections. This explanation dictates the direct quantitative benefits and costs that can be derived after the adoption of free trade and/or government constrained trade policies among nations.

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