The basics of international trade and autarky

International trade involves the exchange of goods and services across national borders. This process can alter how markets function compared to when a country operates in isolation.

Key concepts in trade policy

Autarky is a situation where a country does not engage in international trade and relies solely on its own production to meet domestic demand.

Key trade policy tools:

• Tariff - A tax imposed by a government on imported goods, which increases the price of those imports for domestic consumers.
• Quota - A government-imposed limit on the quantity of a good that can be imported into a country during a specific period.

These policies are tools governments use to influence trade, often to protect domestic industries or generate revenue. Understanding them helps explain shifts in market behavior.

Effects of opening an economy to trade on market equilibria and surpluses

When a country opens its economy to international trade, it moves away from autarky. This change can lead to a new equilibrium where the domestic price aligns more closely with the world price, which is the prevailing price in the global market.

How trade affects market equilibrium

In autarky, the domestic equilibrium price and quantity are determined solely by the intersection of the domestic supply and demand curves. Opening to trade introduces the world price, which can be lower or higher than the autarky price.

Two possible outcomes when opening to trade:

• If the world price is lower than the autarky price, the country becomes an importer. Domestic consumers buy more at the lower price, while domestic producers supply less, creating a shortage filled by imports.
• If the world price is higher than the autarky price, the country becomes an exporter. Domestic producers supply more to take advantage of the higher price, while consumers buy less, creating a surplus that is exported.

The gap between domestic supply and demand at the world price is bridged by trade volume—imports or exports.

Impacts on economic surpluses

Opening to trade affects the welfare of different groups through changes in surpluses.

Key surplus concepts:

• Consumer surplus (CS) - The benefit consumers receive from buying at a price lower than what they are willing to pay. Trade often increases CS for importers by lowering prices.
• Producer surplus (PS) - The benefit producers receive from selling at a price higher than their costs. Trade can increase PS for exporters but decrease it for importers facing competition.
• Total economic surplus - The sum of CS and PS, which generally increases with free trade as resources are allocated more efficiently.

For example, in an importing country, CS rises due to lower prices, but PS falls as domestic producers lose market share. Overall, the gain in CS typically exceeds the loss in PS, leading to a net increase in total surplus.

How tariffs influence markets

Tariffs raise the price of imported goods, making them less competitive compared to domestic products. This policy shifts the market away from free trade outcomes.

Effects of tariffs on price and quantity

When a tariff is imposed on imports, the effective price of the imported good rises by the amount of the tariff.

This leads to:

• A higher domestic price compared to the free trade world price.
• Increased domestic production as local suppliers face less competition.
• Decreased domestic consumption due to the higher price.
• Reduced import quantity, as the tariff makes imports more expensive.

Government revenue is generated from the tariff, calculated as the tariff rate multiplied by the quantity of imports after the tariff.

Impacts on surpluses and deadweight loss

Tariffs redistribute welfare within the economy but also create inefficiencies.

Changes in economic welfare:

• Change in CS - Decreases because consumers pay higher prices and buy less.
• Change in PS - Increases as domestic producers sell more at higher prices.
• Government revenue - A gain equal to the tariff times the post-tariff import quantity.
• Deadweight loss - The net loss in total economic surplus due to inefficient allocation, arising from reduced consumption and overproduction domestically.

The overall total economic surplus decreases compared to free trade, as the deadweight loss represents lost efficiency.

Visualizing tariff effects

To demonstrate a tariff's impact, consider an accurately labeled graph with domestic supply (upward-sloping), domestic demand (downward-sloping), and a horizontal world price line below the autarky equilibrium.

• Under free trade, the equilibrium is at the world price, with imports filling the gap between domestic supply and demand.
• Adding a tariff shifts the import supply curve upward by the tariff amount, raising the domestic price and reducing the import quantity.

This graph shows areas of CS loss, PS gain, government revenue, and deadweight loss triangles.

Worked example - Calculating changes from a tariff

Suppose a country imports widgets with a world price of $10 per unit. Without trade barriers, domestic quantity demanded is 1,000 units, domestic quantity supplied is 400 units, and imports are 600 units. A $2 tariff is imposed, raising the domestic price to $12, where quantity demanded falls to 800 units and domestic supply rises to 500 units.

Calculate the change in imports, government revenue, change in CS, change in PS, and deadweight loss. Assume linear supply and demand for surplus calculations, with CS under free trade at $3,000 and PS at $800.

Step 1: Identify the values

• Free trade imports = 600 units
• Post-tariff imports = 800 - 500 = 300 units
• Tariff rate = $2 per unit
• Free trade CS = $3,000; post-tariff CS = $2,000 (calculated from graph areas)
• Free trade PS = $800; post-tariff PS = $1,250

Step 2: Calculate change in imports and government revenue

Change in imports = 300 - 600 = -300 units

Government revenue = $2 × 300 = $600

Step 3: Calculate changes in surpluses

Change in CS = $2,000 - $3,000 = -$1,000

Change in PS = $1,250 - $800 = +$450

Step 4: Calculate deadweight loss

Deadweight loss = -(change in CS + change in PS + government revenue) = -(-$1,000 + $450 + $600) = -$50

This represents the net loss in total economic surplus.

How quotas affect market outcomes

Quotas limit the quantity of imports, which can drive up domestic prices and alter production levels without directly generating government revenue like tariffs do.

Effects of quotas on price and quantity

By capping imports, a quota reduces the total supply available in the domestic market.

This causes:

• An increase in the domestic price above the world price.
• Higher domestic production to partially fill the gap left by limited imports.
• Lower domestic consumption due to the elevated price.

The quota creates a wedge between the world price and the domestic price, with the difference often captured as extra profit (quota rent) by importers or foreign exporters who hold quota licenses.

Impacts on surpluses

Quotas affect welfare in ways similar to tariffs but without government revenue.

Changes in economic welfare:

• Change in CS - Decreases as consumers face higher prices and reduced quantity.
• Change in PS - Increases for domestic producers who benefit from higher prices and more sales.
• Quota rent - A transfer of surplus to those who receive the import licenses, which could be domestic or foreign entities.
• Deadweight loss - Arises from the inefficiency of reduced trade, leading to a net decrease in total economic surplus.

Although quotas are not graphed in this course, their effects mirror those of tariffs by restricting trade volume and raising prices. For instance, a quota set below the free trade import level will always increase domestic prices and create deadweight loss.