Week 2: The Basic Theory Using Demand and Supply (Ch. 2)

2)
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights

reserved.

trade

Welfare effects of free trade

of a good consumers are willing to buy at each

possible price, holding other influences on demand constant.

The law of demand states that, other things being equal, the lower the price of a good, the higher is the quantity demanded

Other things include tastes, prices of related goods, income, expected future prices etc.

to shift of the demand curve (rather than a movement

along the demand curve
(tastes, prices of related goods, income, expected future prices)

maximum price the consumer is willing to pay for each

unit

As the demand curve is negatively sloped, the consumer is willing to pay less and less for the successive units

Yet, in a competitive market, consumers only pay the market price for these units

Hence, there is a consumer surplus.

the difference between the maximum price the consumer is willing

to pay for a unit (measured on the demand curve) and the price she actually pays for it (the market price).

of a good that producers are willing to supply at

each possible price, holding constant all the other influences on supply

The law of supply states that the higher the price of the good, the higher is the quantity supplied, holding other things constant.

Other things include: prices of factors of production, technology, expected future prices, the number of suppliers etc.

to shift of the supply curve (rather than a movement

along the supply curve

lowest possible price at which a producer would be willing

to supply each unit

As the supply curve is positively sloped, the producer requires higher prices to produce additional units

But, producers actually receive the going market price for these units

surplus is the difference between the price for which a

good sells (the market price) and the minimum amount necessary for the producer to be willing to produce the good (measured on the supply curve)

Percentage of GDP

World Trade and World Production, 1960-2010

represents national demand for the product and S represents national

supply

No trade equilibrium occurs at A (where D=S), with a price of $2000 per motorbike and 40 000 motorbikes demanded and supplied.

form this market as consumer surplus is area c and

producer surplus is area h.

Consumer surplus=c=(1600*40 000)0.5= $32 million

Producer surplus=h=1600*40 000)0.5=$32 million

two countries: the US and The Rest of the World

(ROW)

With no trade, the market equilibrium in the US occurs at A

P=$2000 and Q=40 000.

market equilibrium in The Rest of the World occurs at

H

P=$700 and Q=50 000

One can see profit opportunities at these prices

That is, there will be arbitrage: “buy low” in the Rest of the World and “sell high” in the US

between the two countries, it affects the market prices in

the two countries

Imports to US increase supply and reduce P in the US

The additional demand in the ROW (met by exports) increases price in the ROW.

transportation costs or other frictions, free trade results in the

two countries having the same price for motorbikes, the international price or the world price.

the price that clears the international market, where quantity demanded

of imports equals quantity supplied of exports

The demand for imports can be determined for each possible price

i.e. at P=$2000, there is no excess demand for imports. At P=$1000, there is excess demand of equal to 50 000 units in the US.

can be determined in a similar way

i.e. at p=$700, there

is no excess supply (no export supply). At P=$1000, then excess supply (exports) of 50 000 motorbikes

of $1000, the total world quantity demanded is 90 000

motorbikes (65 000 in the US and 25 000 in the ROW)
The excess demand for motorbikes within the US market is met by the excess supply from the ROW.

Price

lower prices and higher quantities consumed.
Consumers’ net gain=a+b+d
Producers are

hurt by lower prices and fewer units sold
Producers’ net loss=a
Net national gain=b+d

by higher prices and lower consumption
Consumers’ net loss= j+k
Producers gain

from higher prices and higher production
Producer’s net gain=j+k+n
Net national gain=n

The world as a whole
Net world gain=b+d+n

Producers, Consumers, and the Nation as a Whole