International Trade 101

Each year, trillions of dollars worth of goods and services arrive in the United States, and trillions of dollars worth of goods and services leave. Trade is one of the most important economic concepts because trade allows us to specialize - to focus on producing fewer types of goods and services, which leads to increases in productivity and increased productivity leads to better and less expensive goods and services.

Sounds great, right?

Well, even though global trade is beneficial in the aggregate - not everyone benefits from it. When competition increases and products become less expensive, not everyone wins.

Let’s look at a simple example in the market for coffee.

Imagine that trade only occurs between buyers and sellers in country A. So there’s no global trade.

And let’s look at this graphically. On the X axis, we have pounds in millions and on the Y axis, we have the price. The equilibrium price is $4 per pound. And the equilibrium quantity is 2 million pounds of coffee.

Now let’s introduce trade with other countries.

First, we’ll imagine other countries can grow and manufacture coffee at a lower price. In this case, the price in the world market is below the price in the domestic market. So the rest of the world is selling it at $3 per pound, not $4, as shown here with this horizontal line. Note we’ll assume that country A is relatively small and can’t really affect the world price. Now, if trade is allowed and the less expensive goods are imported into country A, the domestic price will eventually decrease to equal the world price. Coffee buyers in country A will now move from buying 2 to 2.5 million pounds of coffee at the new lower price.

When the world price is below the domestic price, domestic consumers gain from trade. So if you’re a coffee buyer in country A, that’s great news for you. For those who are already willing to buy coffee at that higher price, they’re now getting it at a lower price. So this increases their buyer or consumer surplus.

Now, recall, the consumer surplus is the difference between the maximum price a buyer would be willing to pay and that market price. So, for example, say you’re willing to pay $7 for a pound of coffee, but the price of coffee is only $4. Your consumer surplus is the difference, $3. You got the coffee and only had to pay $4. Or as another example, imagine you’re willing to pay $5 for coffee but the price is only $4. Your consumer surplus is $1 in this instance. And total consumer surplus is summing up all individual consumer surplus. Before trade, total consumer surplus was represented by this triangle, CS1. But, by allowing trade, consumer surplus increased to include this entire area.

Consumer surplus increased for two reasons. First, consumer surplus increased for buyers who were already willing to purchase coffee because now they can enjoy the same item at a lower price. This increase in consumer surplus is show here at CS2. Second, the lower price makes it possible for some buyers who wouldn’t have bought coffee at the higher price to now buy it. This increases consumer surplus too. It allows for more trades that wouldn’t have occurred at the higher price and is shown here at CS3. In sum, consumer surplus increased by this amount of both CS2 and CS3. But who loses?

Domestic sellers.

When the world price is below the domestic price, domestic sellers lose from trade. The new equilibrium price is lower than the price before trade with the rest of the world, as shown by the movement from $4 to $3 per pound and domestic sellers sell less coffee. Originally, they sold 2 million pounds of coffee and now they’re selling only 1.5 million pounds of coffee.

Recall that a seller’s gain from trade known as seller or producer surplus, is the difference between the market price of an item and the lowest price they’d be willing to sell that item for. Originally their surplus was shown by this blue shaded triangle, PS1 and PS2 combined, but by allowing trade with other countries, it fell to this smaller area of just PS2.

When the world price is below the domestic price, world sellers gain from trade. So if domestic coffee sellers are only selling 1.5 million pounds of coffee, but domestic buyers are buying 2.5 million pounds of coffee, where is this extra million pounds of coffee coming from?

Sellers from other countries are making up the difference.

An additional 1 million pounds of coffee were imported into country A. Total domestic surplus increases from trade. Now recall that even though domestic sellers lose surplus, total economic surplus for the domestic country has increased. Here is total surplus, both sellers and buyers before opening up trade with other countries. And here is total surplus, after opening up trade with other countries. So we can now see that this area here marks the gains from trade, newly created surplus as a result of trade. And here is where seller surplus is simply being transferred to consumers.

Now, well it may not seem like a big deal since the surplus was simply transferred from seller to buyer. That decrease in seller surplus represents sellers scaling back production and laying off employees.

So, despite the fact that expanding trade increases total surplus in the aggregate, not everyone welcomes this trend. The gains from trade are unevenly distributed and some individuals will be hurt.

Because not everyone wins, governments sometimes restrict trade, usually to protect domestic industries or workers from competition. One way they do so is by enacting a tariff, essentially a tax paid only by foreign sellers on certain types of goods or services imported into the country. This raises foreign sellers’ costs and ultimately increases the world price from here to here. In this example, the tariff increased the price of coffee from $3 to $3.50. In general, trade restrictions such as tariffs, lead to more domestic production and fewer imports. When compared with open trade restrictions result in higher prices, as shown here, and fewer goods sold as shown here. Economists generally support open international trade because it increases the overall productivity and surplus.

In summary, international trade increases because economic surplus increases. In this example, domestic consumers benefit through lower prices and more coffee purchased. But not everyone wins. Increases in competition mean that some businesses can’t sell at that lower price and that many workers at those businesses will lose their jobs. While tariffs seem like an obvious solution, because they support domestic sellers and workers, they result in an inefficient use of resources leading to higher prices for consumers and fewer goods sold - and ultimately a decrease in economic surplus.

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