CHAPTER 2: THE BASIC THEORY USING DEMAND AND SUPPLY
DEMAND - demand curve reflects highest price a consumer is willing to pay for a given unit
A basic determinant of how much a consumer buys of a product is the person’s taste, preferences, or
opinions of the product as well as the price of the product relative to the prices of other products and
the consumer’s income.
Elasticity: the percent change in one variable resulting from a 1 percent change in another variable, is a
measure of responsiveness. The price elasticity of demand is the percent change in quantity demanded
resulting from a 1 percent increase in price.
- Demand is elastic when QD is substantially responsive to price (PED greater than 1); flat demand
- Demand is inelastic when QD is not that responsive (PED less than 1); steep demand
Consumer surplus is the increase in the economic well-being of consumers who are able to buy the
product at a market price lower than the highest price that they are willing and able to pay for the
product. Consumer surplus measures the impact on consumers of a change in market price.
SUPPLY - supply curve reflects the lowest price at which firms are willing to sell a given unit
A firm supplies the product because it is trying to earn a profit on its production and sales activities.
The price that the firm receives for its sales and the cost of producing and selling the product are major
influences on how much a firm supplies.
- If the revenue (price) of selling another unit exceeds the extra (marginal) cost of producing it, the
firm should supply that unit because it makes a profit on it
- The cost of producing another unit depends on: the resources or inputs needed to produce the
extra unit and the prices that have to be paid for these inputs
The price elasticity of supply is the percent increase in quantity supplied resulting from a 1 percent
increase in market price.
- Supply is elastic if QS is substantially responsive to price (PES is greater than 1); flat supply
- Supply is inelastic if QS is not that responsive to price (PES is less than 1); steep supply
Producer surplus is the increase in the economic well-being of producers who are able to sell the
product at a market price higher than the lowest price that would have drawn out their supply. Producer
surplus measures the impact on products of a change in market price.
Opportunity cost is the value of other goods and services that are not produced because resources are
instead used to produce this product.
A national market with no trade is represented by the national demand and the national supply. The
equilibrium then occurs at the price at which the market clears domestically where NQD=NQS.
Demand and supply conditions differ between countries, so prices differ between countries with no
trade.
,TWO NATIONAL MARKETS AND THE OPENING OF TRADE
Two countries are at least needed to discuss international trade. In the international market the desire to
trade is the horizontal difference between national demand and supply.
- The difference between US demand and supply (on the left), is graphed in the center diagram as
the US demand for imports (Dm curve).
- The difference between foreign supply and demand (on the right), is graphed in the center
diagram as the foreign supply of exports (Sx curve)
- The interactions between D and S in both countries determine the world price and quantity
produced, traded, and consumed
- If markets are perfectly competitive, the free-trade price of a good in an importing country is
expected to be lower than the pretrade price of the good in that country
From the initial situation of no trade between two countries, an observant person can profit by initiating
some trade and buying the product at low price (700) in the rest of the world and selling it for a high
price (2000) in the US → this is called arbitrage refers to buying something in one market and reselling
the same thing in another market to profit from a price difference.
Free-trade equilibrium
As international trade develops between the two countries, it affects market prices in the countries:
● The additional supply into the US, created by imports, reduced the market price in the US
● The additional demand met by exports increases the market price in the rest of the world
If there are no transportation costs or other trade frictions, free trade results in two countries having the
same price, called the international price or world price (Pw).
,What will this free-trade equilibrium price be?
- The demand for imports (MD) is the quantity that the country wants to import for each possible
international price. Given it is the excess domestic demand over domestic supply (QD - QS): b + d
- MD = 0 if P=P* (autarky price) but MD > 0 if P<P*
- The supply of exports (XS) is the quantity that the country wants to export for each possible
international price. Given the excess of domestic supply over domestic demand (QS - QD) in the
rest of the world market: n
- XS=0 if P=P* XS>0 if P>P*
- Point E is the free-trade equilibrium where QD for imports equals QS for exports (MD=XS)
A higher world price lowers excess demand (imports) in the country and increases the excess supply
(exports) in the rest of the world. If demand>supply, the price rises, if demand<supply, the price falls.
Effects in the importing country (the US)
Consumers benefit from a lower market price from the imported goods and increase quantity consumed
- Consumers surplus increases
Producers are negatively affected and receive a lower price for their product and shrink production
Domestic producers face foreign competition and lower production
- Producer surplus decreases, there is a loss
Since we cannot say anything about the net effect of trade on the US, economists impose the value
judgment called the one-dollar, one-vote metric; each dollar of gain or loss is valued equally, regardless
of who experiences it.
If the one-dollar, one-vote metric is accepted, then the net national gains from trade equal the
difference between what one group gains and what the other group loses, so area b + d which is
also referred to as the trade triangle → total effect is a net welfare gain
Weakness of one-dollar, one-vote metric: the metric measures the impact of a change in trade on the
basis of effectiveness on aggregate well-being and does not consider how that well-being is distributed
among various economic groups
The net welfare gain (triangle b + d) can be separated into the:
● Consumption effect (right side d): welfare gain due to increase in quantity consumed
● Production effect (left side b): welfare gain due to shifting to cheaper foreign producers
, Effects in the exporting country (rest-of-the-world)
A country will only want to export goods if they can sell the product at a higher price in the foreign
country than the autarky price (domestic country price).
If they can do that they will prefer to sell their goods abroad at a higher price unless domestic consumers
are willing to pay the same higher price in the domestic market. So eventually the domestic market price
will increase because otherwise domestic consumers will not be able to purchase anything since
producers would prefer to sell abroad.
Producers benefit from the increase in market price, production increases
- Producer surplus increases
Consumers are negatively affected by the higher market price, consumption decrease
- Consumer surplus decreases
Using the one-dollar, one-vote metric, we can say that the rest of the world gains from trade, and that
its net gain from trade equals area n, which is also called the trade triangle → total effect is a net gain
Total world gain from trade: b + d + n
- Net gain to consumers from buying any product is the difference between what consumers are
willing to pay for a product and the price they must pay to purchase the product
Which country gains more?
International trade is a positive-sum activity, meaning that most countries gain from international trade,
so the whole world has a net gain.
Free trade makes every country better off, but the gains to the countries are not equal (b + d ≠n). These
two triangles have the same base (the volume of trade) but the height is the change in price so the
country that experiences the larger price change (difference between world price and autarky price) has
the larger value of the net gains from trade.
- The gains from trade are divided in direct proportion to the price changes that trade brings:
- The steeper (more inelastic) the import demand or export supply curve the bigger the price
change and the bigger the welfare gain from trade
- An increase in the world price of a product benefits the exporting countries and hurts importing
countries
