Lecture 2:

Supply, Demand &

Market Equilibrium

Microeconomics
• Basic concepts
• Supply, Demand and Market equilibrium
• Elasticity
• Supply, Demand and Government Policies
• International Trade
• Production and Cost
• Market structures

2 1
 Look for the answers to these questions:
• What determines how much of a good a country will import or
export?
• Who benefits from trade? Who does trade harm? Do the gains
outweigh the losses?
• If policymakers restrict imports, who benefits? Who is harmed?
Do the gains from restricting imports outweigh the losses?
• What are some common arguments for restricting trade? Do
they have merit?

World Price and Comparative Advantage

• PW = the world price of a good, the price that
prevails in world markets
• PD = domestic price without trade
• If PD < PW,
• Domestic country has comparative advantage, country
exports the good
• If PD > PW,
• Domestic country does not have comparative advantage,
country imports the good
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4 2
 A Country That Exports Soybeans
Without trade, P Soybeans
PD = $4 Q = 500
PW = $6 exports S

Under free trade, $6

• domestic consumers demand 300 $4
• domestic producers supply 750
• exports = 450 D
Q
300 500 750

A Country That Exports Soybeans

Without trade, P Soybeans
CS = A + B
S
exports
PS = C $6
A

Total surplus = A + B + C B D
$4 gains
With trade, C from trade
CS = A D
PS = B + C + D Q

Total surplus = A + B + C + D
6

6 3
 Analysis of Trade
Without trade,
PD = $3000, Q = 400 P Plasma TVs
In world markets, S
PW = $1500
• Under free trade, how many
TVs will the country import or $3000
export? $1500
• Identify CS, PS, and total D
surplus without trade, and with 200 400 600
Q
trade.
7

Analysis of Trade
Under free trade,
P Plasma TVs
§ domestic consumers
demand 600 S

§ domestic producers
supply 200 $3000
§ imports = 400
$1500
imports D
Q
200 600

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 Analysis of Trade
Without trade,
CS = A P Plasma TVs
PS = B + C S
Total surplus = A + B + C gains
A
from trade
With trade, $3000
CS = A + B + D B D
$1500
PS = C C imports D

Total surplus = A + B + C + D Q

Winners and Losers From Trade

• Other benefits of international trade
• Consumers: increased variety of goods
• Producers: lower costs - economies of scale
• Increased competition: reduce market power of domestic firms (increase
total welfare)
• Enhanced flow of ideas, facilitates the spread of technological advances
around the world
• Then why all the opposition to trade? The losers have more incentive
to organize and lobby for restrictions on trade:
• Losses: concentrated among a small group of people, who feel them acutely
• Gains: spread thinly over many people, who may not see how trade benefits
them
• The winners from trade could compensate the losers and still be better off

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 International trade

• Free trade: Domestic price = World price

• Protection policies:
• Closed economy: no import or export
• Tariff: Tax on goods produced abroad and sold domestically
• Quota: Quantitative limit on imports of a good

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11

Analysis of a Tariff
P
PW = $20 Cotton shirts
Free trade:
buyers demand 80 S
sellers supply 25
imports = 55
T = $10/shirt
$30
price rises to $30
$20
buyers demand 70 imports D
sellers supply 40 25 40
Q
70 80
imports = 30
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Analysis of a Tariff
Free trade P
Cotton shirts
deadweight
CS = A + B + C + D + E + F
loss = D + F
PS = G
Total surplus = A + B + C + D + E + F + G S
With tariff
CS = A + B A
PS = C + G B
$30
Tax revenue = E C D E F
$20
Total surplus = A + B + C + E + G G
D
DWL= D + F
Q
D = deadweight loss from the overproduction 25 40 70 80
F = deadweight loss from the under-consumption

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International trade Demand Qd = 180-P

Pw = 40
Supply Qs = P
Tariff = 30
190
180
Items Closed Free Trade Tax
170
Price 90 40 70 160
150
Total demand 90 140 110 140
130
Domestic Supply 90 40 70 120
110
Import 0 100 40 100
90
Tax 0 0 1200 80
70
Consumer Surplus 4050 9800 6050 60
50
Producer Surplus 4050 800 2450 40
30
DWL 2500 0 900 20
10
Total Surplus 8100 10600 9700
0
0 20 40 60 80 100 120 140 160 180
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 Demand Qd = 180-P Supply Qs = P
International trade: tariff Pw = 140 Tariff = 20
Items Closed Free Trade Tax 190
180
Price 90 140 120 170
160
150
Domestic demand 90 40 60 140
130
Domestic Supply 90 140 120 120
110
Export 0 100 60 100
90
Tax 0 0 1200 80
70
60
Consumer Surplus 4050 800 1800 50
40
Producer Surplus 4050 9800 7200 30
20
DWL 2500 0 400 10
0
Total Surplus 8100 10600 10200 0 20 40 60 80 100 120 140 160 180

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Import Quotas
• Quantitative limit on imports of a good
• Mostly has the same effects as a tariff:
• Raises price, reduces quantity of imports
• Reduces buyers’ welfare
• Increases sellers’ welfare
• Creates profits for the foreign producers of the
imported goods, who can sell them at higher price

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 International trade: Quota Demand Qd = 180-P Supply Qs = P
Pw = 40 Quota = 60
Free 200
Items Closed Quota 190
Trade 180
Price 40.0 90.0 60 170
160
150
Total demand 140.0 90.0 120 140
130
Domestic Supply 40.0 90.0 60 120
110
Import 100.0 0.0 60 100
90
Tax 0.0 0.0 0 80
70
60
Consumer Surplus 9800 4050 7200 50
40
Producer Surplus 800 4050 1800 30
20
DWL 0.0 2500 400 10
0
Total Surplus 10600 8100 10200 0 20 40 60 80 100 120 140 160 180 200

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Arguments For Restricting Trade

• The jobs argument

• “Trade with other countries destroys domestic jobs”
• Free trade creates jobs at the same time that it destroys them
• Total unemployment does not rise as imports rise, because job losses
from imports are offset by job gains in export industries….
• The infant-industry argument
• “New industries need temporary trade restriction to help them get
started”
• Difficult to implement in practice
• The temporary policy is hard to remove
• Protection is not necessary for an infant industry to grow
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 Arguments For Restricting Trade

• The unfair-competition argument

• “Producers argue their competitors in another country have an unfair
advantage, e.g. due to government subsidies”
• Increase in total surplus for the country
• We should welcome imports of low-cost products subsidized by the other
country’s taxpayers
• The gains to our consumers will exceed the losses to our producers
• The protection-as-a-bargaining-chip argument
• “Trade restrictions can be useful when we bargain with our trading
partners”
• The threat may not work

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Arguments For Restricting Trade

• The national-security argument
• “The industry is vital for national security and it should be
protected from foreign competition, to prevent dependence
on imports that could be disrupted during wartime”
• When there are legitimate concerns over national security
• But producers may exaggerate their own importance to national
security to obtain protection from foreign competition

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 On the diagram below, Q represents the
quantity of peaches and P represents the 1. Refer to Figure Suppose Isoland changes from
price of peaches. The domestic country is a no-trade policy to a policy that allows
Isoland international trade. If the world price of
peaches is $5, then the policy change results in
P a
a. $25 decrease in consumer surplus.
7 b. $20 increase in consumer surplus.
c. $25 decrease in producer surplus.
6 d. $20 increase in producer surplus.
Domestic supply
5
4 2. Refer to Figure Suppose Isoland changes from a
no-trade policy to a policy that allows
3 international trade. If the world price of peaches
2 is $3, then the policy change results in a
Domestic demand a. $15.00 decrease in producer surplus.
1 b. $45.00 increase in consumer surplus.
c. $20.00 increase in total surplus.
d. $12.50 increase in total surplus.
10 20 30 40 50 60 Q

21

On the diagram below, Q represents the quantity of

3. Refer to Figure If Isoland allows international
peaches and P represents the price of peaches. trade and the world price of peaches is $5, then
The domestic country is Isoland
a. producer surplus will be smaller than it would be if
Isoland banned trade.
P b. consumer surplus will be smaller than it would be if
Isoland banned trade.
7 c. the domestic quantity of peaches demanded will
exceed the domestic quantity of peaches supplied.
6 d. Isoland will be an importer of peaches.
Domestic supply
5
4 4. Refer to Figure Suppose Isoland changes from a
3 no-trade policy to a policy that allows international
trade. If the world price of peaches is $5, then the
2 policy change results in
Domestic demand a. a decrease in consumer surplus.
1 b. an increase in producer surplus.
c. an increase in total surplus.
d. All of the above are correct.
10 20 30 40 50 60 Q

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 Price

5. Refer to Figure Without trade, 76 Domestic Supply

72
consumer surplus is
68
a. $100 and producer surplus is $50. 64
b. $100 and producer surplus is $200. 60

c. $400 and producer surplus is $50. 56

d. $400 and producer surplus is $200. 52

48

6. Refer to Figure With free trade, 44

consumer surplus is 40

a. $100 and producer surplus is $50. 36

b. $100 and producer surplus is $200. 32

28 World price + tariff

c. $400 and producer surplus is $50.
24
d. $400 and producer surplus is $200. World Price
20

7. Refer to Figure With trade and a tariff, 16 Domestic Demand

consumer surplus is 12

8
a. $202 and producer surplus is $50.
4
b. $202 and producer surplus is $98.
c. $256 and producer surplus is $50. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Quantity

d. $256 and producer surplus is $98.

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8. Refer to Figure Without trade, total surplus is Price

a. $150. 76 Domestic Supply

b. $300. 72

c. $450. 68

d. $600. 64

60
9. Refer to Figure With free trade, total surplus is 56
a. $150. 52
b. $300. 48
c. $450. 44
d. $600. 40

10. Refer to Figure With trade and a tariff, total 36

surplus is 32

28 World price + tariff

a. $306.
b. $354. 24
World Price
c. $378. 20

d. $426. 16 Domestic Demand

11. Refer to Figure With free trade, the country 12

imports 8

4
a. 5 units of the good.
b. 10 units of the good. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Quantity
c. 15 units of the good.
d. 20 units of the good.
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 Price
12. Refer to Figure The amount of revenue 76 Domestic Supply
collected by the government from the tariff is 72

a. $8. 68

b. $72. 64

c. $180. 60

d. $252. 56

52

48
13. Refer to Figure The deadweight loss
44
caused by the tariff is
40
a. $24. 36
b. $72. 32
c. $96. 28 World price + tariff
d. $150. 24

20 World Price
14. Refer to Figure When comparing no trade to 16 Domestic Demand
free trade, the gain from trade is 12

a. $72. 8

b. $100. 4

c. $150.
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Quantity
d. $450.

25

Price
15. Refer to Figure When the country moves 76 Domestic Supply
from no trade to free trade, consumer surplus
72
a. increases by $300 and producer surplus increases 68
by $150. 64
b. increases by $300 and producer surplus 60
decreases by $150. 56
c. decreases by $300 and producer surplus 52
increases by $150. 48
d. decreases by $300 and producer surplus 44
decreases by $150. 40

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16. Refer to Figure When the country moves 32
from free trade to trade and a tariff, consumer 28 World price + tariff
surplus 24
a. decreases by $144 and producer surplus does not 20 World Price
change. 16 Domestic Demand
b. decreases by $144 and producer surplus 12
increases by $48. 8
c. decreases by $198 and producer surplus does not 4
change.
d. decreases by $198 and producer surplus 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Quantity

increases by $48.

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 Summary
• A country will export a good if the world price of the good is
higher than the domestic price without trade.
• Trade raises producer surplus, reduces consumer surplus, and raises
total surplus.
• A country will import a good if the world price is lower than the
domestic price without trade.
• Trade lowers producer surplus but raises consumer and total surplus.
• A tariff benefits producers and generates revenue for the
government, but the losses to consumers exceed these gains.

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Summary
• Common arguments for restricting trade include:
protecting jobs, defending national security, helping
infant industries, preventing unfair competition, and
responding to foreign trade restrictions.
• Some of these arguments have merit in some cases, but
economists believe free trade is usually the better
policy.

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