(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 645

620 PART • Information, Market Failure, and the Role of Government Cheese (pounds) World Prices Pre-trade Prices CB B Exports A D CD U2 U1 WB Imports WD Wine (gallons) F IGURE 16.12 THE GAINS FROM TRADE Without trade, production and consumption are at point A, where the price of wine is twice the price of cheese With trade at a relative price of cheese to wine, domestic production is now at B, while domestic consumption is at D Free trade has allowed utility to increase from U1 to U2 Suppose now that the trade barrier is dropped and Holland and Italy are both open to trade Suppose also that, as a result of differences in demand and costs in the two countries, trade occurs on a one-to-one basis Holland will find it advantageous to produce at point B, the point of tangency of the 1/1 price line and Holland’s production possibilities frontier That is not the end of the story, however Point B represents the production decision in Holland (Once the trade barrier has been removed, Holland will produce less wine and more cheese domestically.) With trade, however, consumption will occur at point D, at which the higher indifference curve U2 is tangent to the trade price line Thus trade has the effect of expanding Holland’s consumption choices beyond its production possibilities frontier Holland will import WD - WB units of wine and export CB - CD units of cheese With trade, each country will undergo a number of important adjustments As Holland imports wine, the production of domestic wine will fall, as will employment in the wine industry Cheese production will increase, however, as will the number of jobs in that industry Workers with job-specific skills may find it difficult to change employment Not everyone will, therefore, gain as the result of free trade Although consumers will clearly be better off, producers of wine and workers in the wine industry are likely to be worse off, at least temporarily