Chapter 9, Problem 5PA

Subpart (a):

To determine

The impact of free trade on the country.

Explanation of Solution

Here, in the case of the country, the domestic price was $20 and the quantity demanded and supplied was 3 million. Thus, the economy was in its initial equilibrium without trade. When free trade was allowed, the price fell to the world price of $16 and the quantity demanded increased to 4 million, whereas the quantity supplied decreased to just 1 million. This can be illustrated on the graph as follows:

In figure 1, horizontal axis measures quantity and vertical axis measures price. The curve ‘S” and “D’ indicates supply and demand respectively.

Economics Concept Introduction

Concept introduction:

International trade: It is the trade relation between the countries.

Export: It is the process of selling domestic goods in the international market. Thus, the goods produced in the domestic firms will be sold to other foreign countries. So, it is the outflow of domestic goods and services to the foreign economy.

Import: It is the process of purchasing the foreign-made goods and services by the domestic country. Thus, it is the inflow of foreign goods and services to the domestic economy.

Comparative advantage: It is the ability of the country to produce the goods and services at lower opportunity costs than other countries.

Sub part (b):

To determine

The impact of free trade on the country.

Explanation of Solution

From the graph, we can easily identify that the consumer surplus before free trade was the area below the demand curve and above the price line of $20. When the price falls to $16, due to free trade, the consumer surplus increases by the area of A+B+C. The area of A, B, and C can be calculated as follows:

$\begin{array}{c}\text{Area of A}=\left(\begin{array}{l}\left[\left({\text{Price}}_{\text{Higher}}-{\text{Price}}_{\text{Lower}}\right)\left({\text{Quantity}}_1\right)\right]\\ +\left[\frac{1}{2}\times \left({\text{Price}}_{\text{Higher}}-{\text{Price}}_{\text{Lower}}\right)\times \left({\text{Quantity}}_2-{\text{Quantity}}_1\right)\right]\end{array}\right)\\ \left[\left(20-16\right)\left(1,000,000\right)\right]+\left[\frac{1}{2}\times \left(20-16\right)\times \left(\text{3,000,000}-1,000,000\right)\right]\\ =4,000,000+4,000,000\\ =8,000,000\end{array}$

$\begin{array}{c}\text{Area of B}=\left[\frac{1}{2}\times \left({\text{Price}}_{\text{Higher}}-{\text{Price}}_{\text{Lower}}\right)\times \left({\text{Quantity}}_2-{\text{Quantity}}_1\right)\right]\\ =\frac{1}{2}\times \left(20-16\right)\times \left(\text{3,000,000}-1,000,000\right)\\ =4,000,000\end{array}$

$\begin{array}{c}\text{Area of C}=\left[\frac{1}{2}\times \left({\text{Price}}_{\text{Higher}}-{\text{Price}}_{\text{Lower}}\right)\times \left({\text{Quantity}}_3-{\text{Quantity}}_2\right)\right]\\ =\frac{1}{2}\times \left(20-16\right)\times \left(\text{4,000,000}-\text{3,000,000}\right)\\ =2,000,000\end{array}$

Thus, the increase in the consumer surplus can be calculated by adding these together as follows:

$\begin{array}{c}\text{Increase in consumer surplus}=\text{Area of A}+\text{Area of B}+\text{Area of C}\\ =8,000,000+4,000,000+2,000,000\\ =14,000,000\end{array}$

Thus, the consumer surplus increases by $14 million.

Before free trade, the producer surplus (which is the area below the price line of $20)  is above the supply curve, and after free trade, it falls by the area of A. Thus, the producer surplus falls by the area of A, which is equal to $8 million.

The total surplus of the economy after the trade increases by the areas of B+C, which means that the total surplus of the economy has increased by $6 million.

Economics Concept Introduction

Concept introduction:

International trade: It is the trade relation between the countries.

Export: It is the process of selling domestic goods in the international market. Thus, the goods produced in the domestic firms will be sold to other foreign countries. So, it is the outflow of domestic goods and services to the foreign economy.

Import: It is the process of purchasing the foreign-made goods and services by the domestic country. Thus, it is the inflow of foreign goods and services to the domestic economy.

Comparative advantage: It is the ability of the country to produce the goods and services at lower opportunity costs than other countries.