Simple models of comparative advantage are helpful for understanding the fundamental causes of international trade. However, to analyze the effects of international trade at a more detailed level and to understand trade policy, it helps to return to the supply and demand model. We’ll start by looking at the effects of imports on domestic producers and consumers, then turn to the effects of exports.

Figure 5-5 shows the Canadian market for auto seats, ignoring international trade for a moment. It introduces a few new concepts: the domestic demand curve, the domestic supply curve, and the domestic or autarky price.

The domestic demand curve shows how the quantity of a good demanded by residents of a country depends on the price of that good. Why “domestic”? Because people living in other countries may demand the good, too. Once we introduce international trade, we need to distinguish between purchases of a good by domestic consumers and purchases by foreign consumers. So the domestic demand curve reflects only the demand of residents of our own country. Similarly, the domestic supply curve shows how the quantity of a good supplied by producers inside our own country depends on the price of that good. Once we introduce international trade, we need to distinguish between the supply of domestic producers and foreign supply—supply brought in from abroad.

In autarky, with no international trade in auto seats, the equilibrium in this market would be determined by the intersection of the domestic demand and domestic supply curves, point A. The equilibrium price of auto seats would be P_A, and the equilibrium quantity of auto seats produced and consumed would be Q_A. As always, both consumers and producers gain from the existence of the domestic market. Economists refer to the net gain that buyers receive from the purchase of a good as consumer surplus. Likewise, producer surplus is the net gain to sellers from selling a good. Total surplus is the sum of consumer and producer surplus. We analyzed these three concepts in detail in Appendix 3B. In autarky, consumer surplus would be equal to the area of the blue-shaded triangle in Figure 5-5. Producer surplus would be equal to the area of the red-shaded triangle. And total surplus would be equal to the sum of these two shaded triangles.

Now let’s imagine opening up this market to imports. To do this, we must make an assumption about the supply of imports. The simplest assumption, which we will adopt here, is that unlimited quantities of auto seats can be purchased from abroad at a fixed price, known as the world price of auto seats. Figure 5-6 shows a situation in which the world price of an auto seat, P_W, is lower than the price of an auto seat that would prevail in the domestic market in autarky, P_A.

Given that the world price is below the domestic price of an auto seat, it is profitable for importers to buy auto seats abroad and resell them domestically. The imported auto seats increase the supply of auto seats in the domestic market, driving down the domestic market price. Auto seats will continue to be imported until the domestic price falls to a level equal to the world price.

The result is shown in Figure 5-6. Because of imports, the domestic price of an auto seat falls from P_A to P_W. The quantity of auto seats demanded by domestic consumers rises from Q_A to Q_D, and the quantity supplied by domestic producers falls from Q_A to Q_S. The difference between the domestic quantity demanded and the domestic quantity supplied, Q_D − Q_S, is filled by imports.

Now let’s turn to the effects of imports on consumer surplus and producer surplus. Because imports of auto seats lead to a fall in their domestic price, consumer surplus rises and producer surplus falls. Figure 5-7 shows how this works. We label four areas: W, X, Y, and Z. The autarky consumer surplus we identified in Figure 5-5 corresponds to W, and the autarky producer surplus corresponds to the sum of X and Y. The fall in the domestic price to the world price leads to an increase in consumer surplus; it increases by X and Z, so consumer surplus now equals the sum of W, X, and Z. At the same time, producers lose X in surplus, so producer surplus now equals only Y.

The table in Figure 5-7 summarizes the changes in consumer and producer surplus when the auto seats market is opened to imports. Consumers gain surplus equal to the areas X + Z. Producers lose surplus equal to X. So the sum of producer and consumer surplus—the total surplus generated in the auto seats market—increases by Z. As a result of trade, consumers gain and producers lose, but the gain to consumers exceeds the loss to producers.

This is an important result. We have just shown that opening up a market to imports leads to a net gain in total surplus, which is what we should have expected given the proposition that there are gains from international trade. However, we have also learned that although the country as a whole gains, some groups—in this case, domestic producers of auto parts—lose as a result of international trade. As we’ll see shortly, the fact that international trade typically creates losers as well as winners is crucial for understanding the politics of trade policy.

We turn next to the case in which a country exports a good.

Figure 5-8 shows the effects on a country when it exports a good, in this case airplanes. For this example, we assume that unlimited quantities of airplanes can be sold abroad at a given world price, P_W, which is higher than the price that would prevail in the domestic market in autarky, P_A.

The higher world price makes it profitable for exporters to buy airplanes domestically and sell them overseas. The purchases of domestic airplanes drive the domestic price up until it is equal to the world price. As a result, the quantity demanded by domestic consumers falls from Q_A to Q_D and the quantity supplied by domestic producers rises from Q_A to Q_S. This difference between domestic production and domestic consumption, Q_S − Q_D, is exported.

Like imports, exports lead to an overall gain in total surplus for the exporting country but also create losers as well as winners. Figure 5-9 shows the effects of airplane exports on producer and consumer surplus. In the absence of trade, the price of each airplane would be P_A. Consumer surplus in the absence of trade is the sum of areas W and X, and producer surplus is area Y. As a result of trade, price rises from P_A to P_W, consumer surplus falls to W, and producer surplus rises to Y + X + Z. So producers gain X + Z, consumers lose X, and, as shown in the table accompanying the figure, the economy as a whole gains total surplus in the amount of Z.

We have learned, then, that imports of a particular good hurt domestic producers of that good but help domestic consumers, whereas exports of a particular good hurt domestic consumers of that good but help domestic producers. In each case, the gains are larger than the losses.

So far we have focused on the effects of international trade on producers and consumers in a particular industry. For many purposes this is a very helpful approach. However, producers and consumers are not the only parts of society affected by trade—so are the owners of factors of production. In particular, the owners of labour, land, and capital employed in producing goods that are exported, or goods that compete with imported goods, can be deeply affected by trade.

Moreover, the effects of trade aren’t limited to just those industries that export or compete with imports because factors of production can often move between industries. So now we turn our attention to the long-run effects of international trade on income distribution—how a country’s total income is allocated among its various factors of production.

To begin our analysis, consider the position of Maria, an accountant at Ontario Auto Parts, Inc. If the economy is opened up to imports of auto parts from Mexico, the domestic auto parts industry will contract, and it will hire fewer accountants. But accounting is a profession with employment opportunities in many industries, and Maria might well find a better job in the aircraft industry, which expands as a result of international trade. So it may not be appropriate to think of her as a producer of auto parts who is hurt by competition from imported parts. Rather, we should think of her as an accountant who is affected by auto part imports only to the extent that these imports change the wages of accountants in the economy as a whole.

The wage rate of accountants is a factor price—the price employers have to pay for the services of a factor of production. One key question about international trade is how it affects factor prices—not just narrowly defined factors of production like accountants, but broadly defined factors such as capital, unskilled labour, and post-secondary-educated or skilled labour.

Earlier in this chapter we described the Heckscher–Ohlin model of trade, which states that comparative advantage is determined by a country’s factor endowment. This model also suggests how international trade affects factor prices in a country: compared to autarky, international trade tends to raise the prices of factors that are abundantly available and reduce the prices of factors that are scarce.

We won’t work this out in detail, but the idea is simple. The prices of factors of production, like the prices of goods and services, are determined by supply and demand. If international trade increases the demand for a factor of production, that factor’s price will rise; if international trade reduces the demand for a factor of production, that factor’s price will fall.

Now think of a country’s industries as consisting of two kinds: exporting industries, which produce goods and services that are sold abroad, and import-competing industries, which produce goods and services that are also imported from abroad. Compared with autarky, international trade leads to higher production in exporting industries and lower production in import-competing industries. This indirectly increases the demand for the factors used by exporting industries and decreases the demand for factors used by import-competing industries.

In addition, the Heckscher–Ohlin model says that a country tends to export goods that are intensive in its abundant factors and to import goods that are intensive in its scarce factors. So international trade tends to increase the demand for factors that are abundant in our country compared with other countries, and to decrease the demand for factors that are scarce in our country compared with other countries. As a result, the prices of abundant factors tend to rise, and the prices of scarce factors tend to fall as international trade grows. In other words, international trade tends to redistribute income toward a country’s abundant factors and away from its less abundant factors.

The Economics in Action at the end of the preceding section pointed out that U.S. exports tend to be human-capital-intensive and U.S. imports tend to be unskilled-labour-intensive. This suggests that the effect of international trade on U.S. factor markets is to raise the wage rate of highly educated American workers and reduce the wage rate of unskilled American workers.

This effect has been a source of much concern in recent years. Wage inequality—the gap between the wages of high-paid and low-paid workers—has increased substantially over the last 30 years. Some economists believe that growing international trade is an important factor in that trend. If international trade has the effects predicted by the Heckscher–Ohlin model, its growth raises the wages of highly educated North American workers, who already have relatively high wages, and lowers the wages of less educated North American workers, who already have relatively low wages. But keep in mind another phenomenon: trade reduces the income inequality between countries as poor countries improve their standard of living by exporting to rich countries.

How important are these effects? In some historical episodes, the impacts of international trade on factor prices have been very large. As we explain in the following Economics in Action, the opening of transatlantic trade in the late nineteenth century had a large negative impact on land rents in Europe, hurting landowners but helping workers and owners of capital.

The effects of trade on wages in Canada and the United States have generated considerable controversy in recent years. Most economists who have studied the issue agree that growing imports of labour-intensive products from newly industrializing economies, and the export of high-technology goods in return, have helped cause a widening wage gap between highly educated and less educated workers in developed nations like Canada and the United States. However, most economists believe that it is only one of several forces explaining the growth in North American wage inequality.