Chapter 2
The Basic Theory Using Demand and Supply
Overview
This chapter indicates why we study theories of international trade and presents the basic theory
using supply and demand curves. Trade is important to individual consumers, to workers and
other factor owners, to firms, and therefore to the whole economy. The box “Trade Is Important”
provides useful data about the types of products traded and the increasing role of trade in
national economies.
Trade is also contentious, with perpetual battles over government policies toward trade. To
understand the controversy, we need to develop theories of why people trade as they do.
It is useful to organize the analysis of international trade by contrasting a world of no trade with
a world of free trade, leaving analysis of intermediate cases (e.g., non-prohibitive tariffs) for
Chapter 8-14. The analysis seeks to answer four key questions about international trade:
1. Why do countries trade? What determines the pattern of trade?
2. How does trade affect production and consumption in each country?
3. What are the gains (or losses) for a country as a whole from trading?
4. What are the effects of trade on different groups in a country? Are there groups that
gain and other groups that lose?
Theories of international trade provide answers to these four questions.
Basic demand and supply analysis can be used to provide early answers to these four questions,
as well as to introduce concepts that can be used in more elaborate theories. Using motorbikes as
an example, the chapter first reviews the basic analysis of both demand (the demand curve and
the role of the product’s price, other influences on quantity demanded, movements along the
demand curve and shifts in the demand curve, and the price elasticity of demand as a measure of
responsiveness) and supply (the supply curve, the role of marginal cost, other influences on
quantity supplied, movements along the supply curve and shifts in the supply curve, and the
price elasticity of supply). It pays special attention to the meaning and measurement of consumer
surplus and producer surplus. This section, which focuses on review and development of basic
tools, ends with the picture of market equilibrium in a national market with no trade as the
intersection of the domestic demand curve and the domestic supply curve.
The remainder of the chapter examines the use of supply and demand curves to analyze
international trade. If there are two national markets for a product and no trade between them, it
is likely that the product’s price will differ between the two markets. Someone should notice the
difference and try to profit by arbitrage between the two markets. If governments permit free
trade, then the export supply from the initially low-priced market (the rest of the world in the
textbook example) can satisfy the import demand in the initially high-priced market (the United
States in the textbook example), and the world shifts to a free-trade equilibrium. We can show
this free trade equilibrium by deriving the supply-of-exports curve for the rest of the world and
the demand-for-imports curve for the United States. The international market for the product
clears at the intersection of the export-supply and import-demand curves, indicating the
equilibrium international or world price and the quantity traded. This equilibrium world price
also becomes the domestic price in each country with free trade.
The same set of three graphs (the two national markets and the international-trade market) is
used to show the effects of the shift from no-trade to free-trade on different groups in each
country and to show the net gains from trade for each nation. In the importing country consumers
of the product gain consumer surplus and producers of the product lose producer surplus. Using
the one-dollar, one-vote metric, the country as a whole gains, because the gain in consumer
surplus is larger than the loss of producer surplus. In the exporting country producers of the
product gain producer surplus and consumers of the product lose consumer surplus. The analysis
shows that the country as a whole gains because the gain in producer surplus is larger than the
loss of consumer surplus. Furthermore, the country that gains more from the shift to free trade is
the country whose price changes more—the country with the less elastic trade curve (import
demand or export supply).
Tips
We believe that this chapter is an excellent way to introduce the analysis of trade. The four
questions about trade focus student attention on key issues that are interesting to most of them.
Students then get a quick payoff through the use of the familiar supply-demand framework. By
the end of this short chapter we have preliminary answers to all four trade questions. We have
also laid a solid foundation for the analysis of trade using supply and demand curves, the
approach that will receive the most attention in Chapter 8-14 on trade policies.
In class presentations it may be useful to show the graphs in a sequence, perhaps using a series of
slides. After presenting the review of demand and supply and the national market equilibrium
with no trade, the following sequence works well.
1. Two national market graphs with no trade, one with a high no-trade price (the United States),
and one with a low no-trade price (the rest of the world, or ROW). Question to the class: “If
you were the first person to notice this situation, could you make a profit?” This is a good
way to motivate international trade driven by arbitrage.
2. The U.S. national market graph and the international market graph. Question to the class:
“Let’s say that the United States is willing to open up to free trade and integrate into the
world market. If it does this, the world price will also be the price within the United States.
How much will the United States want to import?” It depends on what the world price is. The
instructor can pick one or two hypothetical world price(s) (below the no-trade U.S. price),
and measure the gap between domestic quantity demanded and domestic quantity supplied.
This is the U.S. demand for imports, and these import quantity-price combinations can be
used to plot the U.S. demand-for-imports curve in the international market.
3. A graph of the international market and the ROW national market. A comparable discussion
to item 2 above, to derive the supply-of-exports curve.
4. Superimpose the graphs from item 2 on the graphs from item 3. Question to the class: “What
will happen with free trade? When there is ongoing free trade, what is the equilibrium world
price?” This set of three graphs can be used to show the free-trade equilibrium: world price,
quantity traded, and quantities produced and consumed in each country.
5. A single graph showing the U.S. national market, to contrast no trade with free trade.
Questions to the class: “What group is made happier by the shift from no trade to free trade?
What group is a loser? Can we somehow say that the country gains from free trade?”
6. A single graph showing the ROW national market, with the same questions in item 5.
The next Chapters 3-7 present additional theories of trade. The figure shown on the
accompanying page provides a summary of the key features of these theories. It may be useful to
copy and distribute this figure to your students. If it is distributed when the class begins to study
the material, it can serve as a roadmap. If it is distributed when the class finishes the lectures on
the material, it can serve as a summary and review.
For instructors who want to begin with the discussion of absolute and comparative advantage
rather than with the supply-and-demand framework that focuses on a single product, this should
be possible. After covering the introductory material (the first two pages of Chapter 2, and,
possibly, the two boxes in the chapter), the course would skip to Chapter 3. The remaining
material from Chapter 2 on the supply and demand analysis can be inserted right after Chapter
4’s section referring to analysis using supply and demand curves, or this material can be
presented as a separate topic elsewhere in the course.
Chapter 2 has the first of five boxes about the global financial and economic crisis that began in
2007 and became dramatically worse in 2008. The box “The Trade Mini-Collapse of 2009”
documents and discusses the sharp decline in global trade that began in late 2008 (and the
bounce back that occurred in 2010). With the series of boxes and the discussion of the global
crisis in the final section of Chapter 21, an instructor can weave discussions of the global crisis
and its aftermath throughout a course.