its one of the topic in agricultural trade and policy that explains how domestic producers, consumer benefit from international trade as well as its effect on national and international welfare

1. AGRICULTURAL TRADE AND
POLICY
Dr. Horace Phiri
Department of Agricultural and Applied Economics
LECTURE 2
GAINS FROM TRADE

2. TODAY’S PLAN
1. Introduce international economics
2. Introduce the general equilibrium model of international
trade
3. Use the small country model to understand opportunity
costs and the gains from trade
4. Use the two-country model to understand gains from
trade

3. What is international economics?
• International economics is a field of study which
assesses the implications of international trade in
goods and services and international investment
• It has two broad sub categories
– International Trade
– International Finance

4. What is international trade?
• International trade is a field in economics that
applies microeconomic models to help understand
the international economy.
• Its content includes supply and demand analysis,
firm and consumer behavior, market structures,
and the effects of market distortions.
• The objective of an international trade course is to
understand the effects on individuals and
businesses because of international trade itself

5. What is international finance?
• International finance applies macroeconomic
models to help understand the international
economy.
• Its focus is on the interrelationships between
aggregate economic variables such as GDP,
unemployment rates, inflation rates, trade
balances, exchange rates, interest rates, etc.

6. Some Terminology
• Two extreme states or conditions could potentially
be created by national government policies.
• At one extreme, a government could pursue a
"laissez faire" policy with respect to trade and thus
impose no regulation whatsoever that would
impede (or encourage) the free voluntary
exchange of goods between nations. We define
this condition as free trade.

7. • At the other extreme, a government could
impose such restrictive regulations on trade
as to eliminate all incentive for international
trade.
• We define this condition in which no
international trade occurs as national
autarky. Autarky represents a state of
isolationism

8. • Probably, a pure state of free trade or autarky has
never existed in the real world. All nations impose
some form of trade policies.
• And probably no government has ever had such
complete control over economic activity as to
eliminate cross-border trade entirely.

9. • Most policy discussions are not about whether
governments should pursue one of these two
extremes.
• Instead, discussions focus on which direction a
country should move along the trade spectrum
• A movement in the direction of autarky occurs
whenever a new trade policy is implemented if it
further restricts the free flow of goods and services
between countries.

10. • Since new trade policies invariably benefit
domestic industries by reducing international
competition, it is also referred to as protectionism

11. The “Small-Country” General Equilibrium Model
• The small-country model assumes that the actions of its
citizens have no noticeable effects on foreign prices or the
quantities produced by foreign industries.
• The model’s general equilibrium nature means that it traces
the effects of an economic change to all sectors of the
domestic economy.
• To enable us to use two-dimensional diagrams, the model
assumes that there are just two industries in the economy.
• The model uses a production possibilities frontier to
represent the supply side of the economy.
• It uses indifference curves to represent consumer
preferences and the demand side of the economy.

12. The Small-Country General Equilibrium Model
• The model uses a
production possibilities
frontier (PPF) to represent
the supply side of the
economy
• The PPF is “bowed out” to
reflect increasing costs
• The PPF tells us how
much of one good we
must sacrifice in order to
make available the
resources to produce one
more of the other good
PPF
Food
0 100 200 300 350 400 Clothing
200
300
100
400
350

13. What determines the location and
shape of the PPF?
• The PPF can be drawn with information on
resources and technology (endowments and
production functions).
• It is about what is possible, not what occurs.
• The PPF is bowed out if opportunity costs
are increasing.

14. Will the economy operate on the
PPF?
• That is a question about market outcomes.
• Opportunity cost is another name for relative
marginal costs.
• Firms respond to product prices – do prices reflect
marginal costs?
• If firms are competitive, and there are no
distortions in the economy, the economy will
operate on the PPF. (Remember P=MR=MC)

15. The Small-Country General Equilibrium Model
• If efficient, a closed
(autarky) economy
produces and consumes
at points located on the
PPF.
• The points B, C, and D
are all attainable.
• Note that the point D
implies that not all
available resources and
technology are being
exploited.
• The point A outside the
PPF is not feasible.
PPF
Food
0 100 200 300 350 400 Clothing
200
300
100
400
• A
350
C
B
D•

16. The Small-Country General Equilibrium Model
• The welfare-maximizing
production/consumption
combination is at the point
where the PPF and the
indifference curves have the
same slope.
• The tangency between the
PPF and the indifference
curve at A is the point where
the opportunity costs of
producing food and clothing
are equal to the relative
marginal benefits from
consuming food and clothing.
A
Food
p
0 100 200 300 400 500 Clothing
I1 I2
I3
200
300
100
400

17. Conditions for autarky equilibrium
• Producers must be happy producing what they are
producing: Px/PY=MRTS – relative price of X
equals opportunity cost in production.
• Consumers must be happy consuming what they
are consuming: Px/PY=MRS – relative price of X
equals the marginal rate of substitution.
• Market clearance: supply equals demand.

18. The Gains from Trade
• If the world price ratio is
different from the domestic
price ratio p, an open
economy can use foreign
trade to reach consumption
points outside its PPF.
• The diagram shows the
consumption possibilities
line (CPL) whose slope
reflects the world price
ratio.
• A small open economy that
continues to produce at A
can consume anywhere
along the CPL.
A
Food
CPL
p
0 100 200 300 400 500 Clothing
200
300
100
400 P
I1 I2

19. The Gains from Trade – exchange only
• Given the bundle of food
and clothing produced at A,
welfare maximization will
take consumers to point B,
the tangency between the
indifference curve and the
CPL.
• At B, the relative marginal
gains from consuming food
and clothing are equal to the
world price ratio.
• The trade triangle connects
points A and B.
A
Food
CPL1
p
0 100 200 300 400 500 Clothing
I2 I3
200
300
100
400
C
B
CPL2

20. The Gains from Trade – adding specialization
• An open economy can
achieve further gains from
trade by specializing.
• By shifting production
from A to P, a higher CPL
can be reached.
• Given production and
income generated at P,
consumers choose to
consume at point C.
A
Food
CPL1
p
0 100 200 300 400 500 Clothing
I2
I3 I4
200
300
100
400
C
B
P
CPL2
D

21. The Gains from Trade
• The combination of
exchange and specialization
takes the country to a higher
welfare level.
• Compare the smaller
exchange-only trade triangle
connecting points A and B
with the trade and
specialization trade triangle
connecting points P and C.
• With exchange and
specialization, a higher
indifference curve comes
within reach.
A
Food
CPL1
p
0 100 200 300 400 500 Clothing
I1 I2
I3 I4
200
300
100
400
C
B
P
CPL2
D

22. What do economists mean by gains?
• These indifference curves are fictions. There is no
easy way to compare the “goodness” of different
aggregate bundles.
• Clearly distribution matters, but it is ignored in
this analysis.
• When we say gains we mean consumption
possibilities.
• Market responses to trade imply overall gains but
individual winners and losers.
• Economics helps you figure out who these are!

23. Summarizing the Results of the Simple Two-Good Model
• When relative prices (opportunity costs) of goods
are not the same at home and abroad, countries can
increase national welfare by engaging in
international trade.
• The gains from exchange are the result of domestic
consumers substituting the relatively cheaper foreign
products for the relatively more expensive domestic
products.
• The gains from specialization are the gains from
shifting domestic resources away from producing
products that are relatively cheaper overseas to those
products that are relatively more expensive overseas.

24. • An economy can enjoy the
gains from exchange
without specializing, but it
cannot enjoy the gains from
specialization without
trading.
• Merely shifting production
to P only reduces welfare, as
evidenced by the lower
indifference curve passing
through P.
• It takes exchange to get to C
and the higher indifference
curve.
A
Food
CPL1
p
0 100 200 300 400 500 Clothing
I1 I2
I3 I4
200
300
100
400
C
B
P
CPL2
D
There Are No Gains from Specialization Without Exchange

25. The Two-Country General Equilibrium Model
• The small-country model can only tell us how one country
is affected by international trade.
• This assumes that there are no effects on the rest of the
world. More importantly, it doesn’t tell us why relative
prices differ.
• In general, international trade causes changes in prices and
shifts in resources both at home and abroad.
• We therefore develop a two-country general equilibrium
model that explains trade between two countries and
describes the many changes that occur in both countries as
a result of the opening up of trade.

26. Suppose there are two countries, each with its own unique PPF
Homeland Abroad
I1 I2 I3
A
A*
p
p*
Food Food
Clothing Clothing
I1 I2 I3

27. Trade between the two countries will cause each country’s relative prices
to move in the direction of the other country’s realtive price ratio:
Homeland Abroad
I1 I2 I3
A
C
p
p*
C*
A*
pW
pW
Food Food
Clothing Clothing
I1 I2 I3

28. In the absence of barriers to trade or transport costs, trade will grow
until the price ratios have become equal in both countries, as
illustrated by the common price line Pw:
Homeland Abroad
I1 I2 I3
A
C
P
P*
C*
A*
pW
pW
Food Food
Clothing Clothing
I1 I2 I3

29. Production shifts to P and P*, respectively, and consumption shifts
to C and C* in each country. Welfare rises in both countries:
Homeland Abroad
I1 I2 I3
A
C
P
P*
C*
A*
pW
pW
Food Food
Clothing Clothing
I1 I2 I3

30. Figure 3-9
Two-Country Model: The Free Trade Triangles
Homeland Abroad
I1 I2 I3
A
C
P
P*
C*
A*
exports
imports
e
x
p
i
m
p
pW
pW
Food Food
Clothing Clothing
I1 I2 I3

31. The 2-Country General Equilibrium Model
• The two-country model
shows that both countries
gain from trade; each
reaches a higher
indifference curve.
• Each country specializes
in producing products for
which it has the lower
opportunity costs.
• One country’s exports are
the other’s imports.
• Relative prices are
equalized across both
countries.
Homeland Abroad
I1 I2 I3
A
C
P
P*
C*
A*
exports
imports
e
x
p
i
m
p
pW
pW
Food Food
Clothing Clothing
I1 I2 I3

32. Why do opportunity costs differ?
• Technological differences
• Differences in factor proportions
• Differences in tastes
• Does country size matter? It doesn’t if there
are no scale economies and tastes are
“homothetic.”
• When will size matter? Is that important?

33. • We will spend the next 4 weeks analyzing
what causes the differences in costs and in
so doing explaining why trade takes place
between countries