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International Trade: A Market Analysis

Study Supplement for Econ 371 Revised 2/1/2008 There are at least two useful ways to think about the markets where international trade takes place. Lets use the market for a particular category of automobiles as an example. The First Image of Trade: One Big Market. One way to think about international trade is in terms of a regional or global market for a particular good, such as autos. The market connects buyers (demand) wherever they happen to live with the producers (supply) wherever they happen to be located. This first image of the market is thus plain old supply and demand and the market acts to determine an equilibrium price such that the quantity demanded of autos in the world or region is equal to the quantity supplied. The law of one price predicts that the prices that buyers pay and sellers receive within the market, wherever they are located, will tend to converge on the equilibrium price, plus or minus any transactions costs or side-payments that individual buyers and sellers receive.

The first image of trade: supply & demand In this first image of trade, anything that affects global (or regional) supply or demand will affect all consumers and producers through shared market forces. For example. Toyota has recently set a goal of becoming the worlds largest auto firm by the end of the decade and has opened a number of auto factories (and expanded existing factories) around the world. Toyotas strategy can be seen as an increase in the supply of automobiles (a shift in the supply curve out and to the right). This creates a surplus of autos A <->B at the initial equilibrium price. The surplus tends to drive down the price of all autos in this market.

Toyota increases global auto supply The graph shows us that consumers purchase more autos (movement along the demand curve from A > C in the graph below). At the same time, some of Toyotas competitors reduce the number of autos they produce in response to the lower price (a movement along the supply curve from B > C in the graph). The increase in quantity demanded and decrease in quantity supplied eventually eliminates the auto surplus at the new equilibrium point C. If Toyotas increase in supply is large enough and if the decrease in quantity supplied by other auto firms is large enough plus the increase in quantity demanded in large enough Toyota may achieve its goal of becoming the #1 global auto firm. I sure wouldnt bet against it. Toyota cars, such as the Prius and the Yaris, have been flying off dealer lots, according to the Wall Street Journal (8/10/2006). Seven of the ten hottest selling cars in the U.S. were Toyota brands (Toyota, Scion and Lexus). This first image of international trade is both very simple and often also very useful, especially when we are examining highly integrated global (or regional) markets, such as automobiles, where production takes place in many locations, and when we are considering issues that affect suppliers and demanders through market forces wherever they are located. This is the image of international trade that comes most naturally to economists, I suppose, because we tend to think of people

3 as buyers and sellers first and as residents of particular countries second. International trade, after all, takes place within markets (not between countries) and, from a supply-demand standpoint, international markets (markets that cross national borders) are not fundamentally different from markets that have as their domains buyers and sellers in the same city, region or country. The Second Image of Trade: Connected National Markets. Sometimes, however, national borders do matter (as, for example, when we consider international trade policies), so it is useful to use a second image of international trade. The second image of international trade breaks down the global market into its national market components and the interactions between and among them through international markets. Here, for example, we see the markets automobiles in Japan and the United States. We begin by imagining what the national supply and demand curves would be in autarky, which is a state where there is no international trade and each nations price is determined purely by domestic supply and demand forces.

The second image of trade: national and international markets In the graphs above, for example, we can see that, in the absence of international trade, the price of a particular category of autos in Japan would be a relatively low P/A while the price for the same kind of cars in the United States might be a relatively higher P/a (uppercase letters are used for Japan and lowercase for the U.S. in this example). It is clear that Japanese producers and U.S. buyers would benefit if an international market were created to link the two domestic auto markets because U.S. buyers would like access to lower price Japanese cars and Japanese auto firms would like the opportunity to sell cars at the higher U.S. prices. If there are no significant barriers to international trade (such as export restrictions in Japan or import barriers in the U.S. or transportations costs that exceed the price gap) we would expect such a market to develop. What would this international market look like?

The X-curve The figure above begins the process of building the international market. Japanese producers would be willing to export autos at prices above their autarky equilibrium price of P/A. At P/A there is a domestic market equilibrium, so there would be no surplus of autos available for export. But as the price rises above P/A, and increasing export supply would appear. As the price rises above P/A, there would be both an increase in quantity supplied Qs in Japan (movement along the S curve) and also a decrease in quantity demanded Qd (movement along the D curve). The combination of greater Qs and lower Qd would produce the export supply curve X in the center graph. Qx in the international market = Qs Qd in the Japan market. The quantity of export supply Qx at each price above P/A is equal to the difference in Qs and Qd in Japan at that price. The higher the international price, the greater the Qx available.

The X-M model of trade Similar logic creates the import demand curve M shown in the figure above. At its high autarky equilibrium price P/a, the U.S. would have no need for imports because there would be a domestic supply-demand equilibrium. At prices below P/a, however, a demand for imports would appear because, at lower prices, the domestic Qd would be higher and the domestic Qs would be lower (movements along the U.S. supply and demand curves). The import demand curve M in the international market shows the quantity of desired imports Qm at each price. Qm in the international market =Qd-Qs in the U.S. market.

Autarky to trade The world market price P/w is set by the international of export supply X and import demand M on the international market. P/w is the price where the quantity of export supply in Japan (the difference between C and B in the Japan market) is equal to the quantity of import demand in the U.S. (the difference between b and c in the U.S. market). Autarky to Trade Analysis We can use these graphs to understand how the opening of trade affects consumers and producers in the national markets. Begin with both nations in autarky at P/A and P/a respectively. The relatively lower auto price in Japan tempts businesses to begin to export autos from Japan to the U.S. As this trade opens up, the price of autos rises in Japan (in order to create a surplus or autos to satisfy the U.S. market). As the price rises, the domestic Qd will decrease (A>B along the D curve) and the domestic Qs will increase (A>C along the S curve) creating the export supply equal to B <->C at P/w. Meanwhile in the U.S., the availability of autos from Japan will create a surplus of autos and push prices down. As the price falls there will be an increase in the Qd of autos a>b along the D curve and a decrease in the Qs a>c along the S curve. This creates an import demand equal to c <->b at P/w. At the new price of P/w there is a surplus of autos produced in Japan which is exported to the U.S. to satisfy the import demand. Prices have converged from the autarky prices of P/A and P/a to the new international market price P/w. A quick winner/loser analysis suggests that Japans auto producers have gained from the movement from autarky to trade because they are producing more autos at a higher price and the U.S. auto producers have lost, since they produce fewer autos at a lower price. U.S. auto buyers have gained, however, because they can purchase more autos at a lower price while Japans auto buyers have lost, since they purchase fewer autos at a higher price than in autarky.

Application of the Second Image of Trade Suppose that Toyota has increased its production capacity for automobiles in Japan. How does this affect international trade between the US and Japan? The graph below provides analysis. Toyotas investment in Japanese production increases the supply curve for autos in Japan and therefore also increases the X curve for autos by increasing the supply of Japans autos available for export to the US. This shift in the X curve creates a surplus of autos on the international market, which drives down the world market price from P/w to P/w in the graph.

A variety of adjustments take place as the world market price falls. First, consumers in both countries are encouraged (by the lower price) to purchase more autos in (increases in the Qd in both countries due to the lower price). There are also affects on the Qs in both countries. In the U.S. the lower price is an incentive for domestic firms to reduce auto production (a decrease in the Qs is movement along the supply curve). The same thing happens in Japan. Although Toyota has increased production (shift in the S curve), other Japan firms are encouraged by the falling price to reduce production (movement along the new S curve). So Toyotas increase in production (assuming that it is large enough to have these market effects) both serves to increase the size of the total auto market and discourages other automakers from producing cars because of the falling price. This is, of course, the same basic conclusion that we made with analysis of the first image, but with additional insights concerning the national as well as international effects of Toyotas strategy. The first image analysis helps us to see the big market forces at work in international trade, while the second image allows us to break down the effects and see how different countries are affected. Which image we use depends in part upon the industry we choose, how important global effects are versus national effects, and what type of question we are trying to answer.

Welfare analysis of International Trade. As noted above, international trade creates winners and losers within each country. In our auto example, for instance, U.S. auto buyers gain from the existence of international trade through lower prices but U.S. auto producers lose from decreased sales and profits. How do know that the U.S. gains overall from trade, as the proponents of free trade tell us? One way to answer this question is to perform what economists call a welfare analysis of trade versus autarky. This is does by calculating the size of the gain by auto buyers and comparing it with the amount that auto producers lose. If the consumer gain is greater that the producer loss, we conclude that there is a net gain to the economy. How do we measure consumer and producer gains and losses? We use the tools of consumer surplus (to measure consumer gain or loss) and producer surplus (to measure producer gain or loss). Producer and consumer surplus give us estimates of the size of the gains and losses in terms of dollars of real income. These tools are explained in Carbaughs textbook, pages 111112 (10th edition) or 116-118 (11th edition). Please review Carbaughs explanation now, before you read the next paragraph.

Welfare analysis of U.S. auto trade Looking at the U.S. in autarky, the figure above left, we see the initial distribution of consumer and producer surplus. Consumer surplus (shown by the red /// shading on the graphs) is the difference between the price that buyers pay in the market and the price that they would be willing to pay the area between the price line and the demand curve above it. Producer surplus (shown by the green \\\\ shading) is the difference between the price that sellers receive in the market and the lowest price that they would be willing to sell for the area between the supply curve and the price line above it.

8 Moving from autarky to trade allows U.S. consumers to purchase more automobiles and to pay less for the domestic autos that they would have purchased anyway. This increases their consumer surplus by an amount equal to the areas r+s+t in the graph (r+s is the gain from lower prices alone; t is the gain from increased auto purchases made possible by the lower price). Producers lose from trade in this case. Their loss is given by area r in the graph. The net gain to the U.S. is therefore s+t the amount by which the consumer gain exceed the producer loss.

We can also calculate the net gain in Japan. Auto consumers lose because international trade drives up auto prices in Japan and reduces the amount that consumers purchase. This loss in consumer surplus is equal to area x in the graph. Producers gain, however, both because they call profitably sell more autos and also because they receive a higher price for all of the autos they sell (this is the law of one price if U.S. buyers are willing to pay more for autos, then Japanese buyers will have to pay more, too). The gain in producer surplus is equal to x+y+z, where x+y is the gain from higher prices alone and z is the gain from increased production and sales. The net gain to Japan is thus y+z. The welfare analysis suggests that both nations gain from trade, just as David Ricardo predicted. But how much do they gain? This question is answered in Chapter 2 of Douglas Irwins book, Free Trade Under Fire.