If you check the labels on the clothes you are now wearing you will probably find that some of your clothes were made in another country. A century ago, the textiles and clothing industry was a major part of the US economy, but that is no longer the case. Faced with foreign competitors that can produce quality goods at low cost many US firms have found it increasingly difficult to produce and sell textiles and clothing at a profit. As a result they have laid off their workers ad shut down their factories. Today, much of the textiles and clothing that Americans consume are imported.
The story of the textiles industry raises important questions for economic policy: How does international trade affect economic well being? Who gains and who loses from free trade among countries and how do the gains compare to the losses?
The study of international trade by applying the principle of comparative advantage:
According to this principle all countries can benefit from trading with one another because trade allows each country to specialize in doing what it does best. But the analysis was complete. It did not explain how the international marketplace achieves these gains from trade or how the gains are distributed among various economic participants.
We now to the study of international trade and take up these questions. Over the several articles we have developed many tools for analyzing markets work, supply demand equilibrium consumer surplus producer surplus, for so on. Wit these tools, we can learn more about how international trade effects economic well being.
The determinants of trade
Consider the market or steel. The steel market is well suited to examining the gains and losses from international trade. Steel is made in many countries around the world and there is much world trade in steel. Moreover, the steel market is one in which policymakers often consider (and sometimes implement) trade restrictions to protect domestic steel producers from foreign competitors. We examine here the steel market in the imaginary country of Isoland.
The Equilibrium without trade
As our story begins the Isolandian steel market is isolated from the rest of the world. By government decree, no one in Isoland is allowed to import or export steel, and the penalty for violating the decree is so large that no one dares try.
Because there is no international trade, the market for steel in Isoland consists solely of Isolandian buyers and sellers as figure shows the domestic price adjusts to balance the quantity supplied by domestic sellers and the quantity demanded by domestic buyers . The figure shows the consumer and producer surplus in the equilibrium, without trade. The sum of consumers and producer surplus measures the total benefits that buyers and sellers receive from the steel market.
Now suppose that, in an election upset, Isoland elects a new president. The president campaigned on a platform of change and promised the voters bold new ideas. Her first act is to assemble a team of economists to evaluate Isolandian trade policy She asks them to report on three questions.
1) If the government allows Isolandians to import and export steel, what will happen to the price of steel and the quantity of steel sold in the domestic steel markets?
2) Who will gain from trade in steel and who will lose and will the gains exceed the losses?
3) Should a tariff a tax on steel imports be part of the new trade policy?
World price and Comparative Advantage:
The first issue our economists take up is whether Isoland is likely to become a steep importer or a steel exporte. In other words, if the trade is allowed will Isolandians end up buying or selling in world markets.
To answer his questions the economist compares the current Isolandian price of steel to the price of steel in other countries. We call the price prevailing in world markets the world price. If the world price of steel is higher than the domestic price, then Isoland will export steel once trade is permitted Isolandian steel producers while be eager to receive the higher process available abroad and will start selling is lower than the domestic price, then isoland will import steel. Because foreign sellers offer a better price isolandian steel consumers will quickly start buying steel from other countries.