The Basic Theory Using Demand and Supply

Key points
Consumer surplus and producer surplus
National welfare with no trade
Welfare effects of free trade

1. Demand & Consumer Surplus
A Demand curve shows how much of a good consumers are willing to buy at each possible price, holding other influences on demand constant.
The law of demand states that, other things being equal, the lower the price of a good, the higher is the quantity demanded
Other things include tastes, prices of related goods, income, expected future prices etc.

1. Demand & Consumer Surplus
Changes in these other things lead to shift of the demand curve (rather than a movement along the demand curve
(tastes, prices of related goods, income, expected future prices)

1. Demand & Consumer surplus
Consumer surplus
The demand curve shows the maximum price the consumer is willing to pay for each unit
As the demand curve is negatively sloped, the consumer is willing to pay less and less for the successive units
Yet, in a competitive market, consumers only pay the market price for these units
Hence, there is a consumer surplus.

1. Demand & Consumer surplus
Consumer surplus is a measure of the difference between the maximum price the consumer is willing to pay for a unit (measured on the demand curve) and the price she actually pays for it (the market price).

2. Supply & Producer Surplus
A supply curve shows the quantity of a good that producers are willing to supply at each possible price, holding constant all the other influences on supply
The law of supply states that the higher the price of the good, the higher is the quantity supplied, holding other things constant.
Other things include: prices of factors of production, technology, expected future prices, the number of suppliers etc.

2. Supply & Producer Surplus
Changes in these other things lead to shift of the supply curve (rather than a movement along the supply curve

2. Supply & Producer Surplus
Producer Surplus
The supply curve shows the lowest possible price at which a producer would be willing to supply each unit
As the supply curve is positively sloped, the producer requires higher prices to produce additional units
But, producers actually receive the going market price for these units

2. Supply & Producer Surplus
Hence there is a producer surplus.
Producer surplus is the difference between the price for which a good sells (the market price) and the minimum amount necessary for the producer to be willing to produce the good (measured on the supply curve)

Figure 2.1 Demand and Supply for Motorbikes

Case study 1: Trade is important
Exports Plus Imports as a Percentage of GDP

Case Study 2: The Trade mini collapse of 2009
Volume of World Trade and World Production, 1960-2010

3. National market with no trade
In the following figure, D represents national demand for the product and S represents national supply
No trade equilibrium occurs at A (where D=S), with a price of $2000 per motorbike and 40 000 motorbikes demanded and supplied.

3. National market with no trade
Both consumers and producers benefit form this market as consumer surplus is area c and producer surplus is area h.
Consumer surplus=c=(1600*40 000)0.5= $32 million
Producer surplus=h=1600*40 000)0.5=$32 million

Figure 2.2 The Market for Motorbikes: Demand and Supply

4. National markets & opening of trade
Suppose that there are two countries: the US and The Rest of the World (ROW)
With no trade, the market equilibrium in the US occurs at A
P=$2000 and Q=40 000.

4. National markets & opening of trade
With no trade, the market equilibrium in The Rest of the World occurs at H
P=$700 and Q=50 000
One can see profit opportunities at these prices
That is, there will be arbitrage: “buy low” in the Rest of the World and “sell high” in the US

4. National markets & opening of trade
As international market develops between the two countries, it affects the market prices in the two countries
Imports to US increase supply and reduce P in the US
The additional demand in the ROW (met by exports) increases price in the ROW.

4. National markets & opening of trade
If there are no transportation costs or other frictions, free trade results in the two countries having the same price for motorbikes, the international price or the world price.

4. National markets & opening of trade
Free-trade equilibrium occurs at the price that clears the international market, where quantity demanded of imports equals quantity supplied of exports
The demand for imports can be determined for each possible price
i.e. at P=$2000, there is no excess demand for imports. At P=$1000, there is excess demand of equal to 50 000 units in the US.

4. National markets & opening of trade
The supply of exports can be determined in a similar way
i.e. at p=$700, there is no excess supply (no export supply). At P=$1000, then excess supply (exports) of 50 000 motorbikes

4. National markets & opening of trade
At the world price of $1000, the total world quantity demanded is 90 000 motorbikes (65 000 in the US and 25 000 in the ROW)
The excess demand for motorbikes within the US market is met by the excess supply from the ROW.

Figure 2.3 The Effects of Trade on Production, Consumption, & Price

5. The welfare effects of free trade
The US
Consumers benefit from lower prices and higher quantities consumed.
Consumers’ net gain=a+b+d
Producers are hurt by lower prices and fewer units sold
Producers’ net loss=a
Net national gain=b+d

5. The welfare effects of free trade
The ROW
Consumers are hurt by higher prices and lower consumption
Consumers’ net loss= j+k
Producers gain from higher prices and higher production
Producer’s net gain=j+k+n
Net national gain=n
The world as a whole
Net world gain=b+d+n

Figure 2.4 The Effects of Trade on Well- Being of Producers, Consumers, and the Nation as a Whole