According to the principle of comparative advantage, the best economic outcomes occur when each nation specializes in the goods and services at which it is relatively most productive and then trades with other nations to obtain the goods and services its citizens desire.
The production possibilities curve (PPC) of a country is a graph that describes the maximum amount of one good that can be produced at every possible level of production of the other good. At any point the slope of a PPC indicates the opportunity cost, in terms of forgone production of the good on the vertical axis, of increasing production of the good on the horizontal axis by one unit. The more of a good that is already being produced, the greater the opportunity cost of increasing production still further. Thus the slope of a PPC becomes more and more negative as we read from left to right. When an economy has many workers, the PPC has a smooth, outwardly bowed shape.
A country's consumption possibilities are the combinations of goods and services that might feasibly be consumed by its citizens. In a closed economy—one that does not trade with other countries—the citizens' consumption possibilities are identical to their production possibilities. But in an open economy—one that does trade with other countries—consumption possibilities are typically greater than, and never less than, the economy's production possibilities. Graphically, an open economy's consumption possibilities are described by a downward-sloping line that just touches the PPC, whose slope equals the amount of the good on the vertical axis that must be traded to obtain one unit of the good on the horizontal axis. A country achieves its highest consumption possibilities by producing at the point where the consumption possibilities line touches the PPC and then trading to obtain the most preferred point on the consumption possibilities line.
In a closed economy, the relative price of a good or service is determined at the intersection of the supply curve of domestic producers and the demand curve of domestic consumers. In an open economy, the relative price of a good or service equals the world price—the price determined by supply and demand in the world economy. If the price of a good or service in a closed economy is greater than the world price and the country opens its market to trade, it will become a net importer of that good or service. But if the closed-economy price is below the world price and the country opens itself to trade, it will become a net exporter of that good or service.
Although free trade is beneficial to the economy as a whole, some groups—such as domestic producers of imported goods—are hurt by free trade. Groups that are hurt by trade may be able to induce the government to impose protectionist measures, such as tariffs or quotas. A tariff is a tax on an imported good that has the effect of raising the domestic price of the good. A higher domestic price increases domestic supply, reduces domestic demand, and reduces imports of the good. A quota, which is a legal limit on the amount of a good that may be imported, has the same effects as a tariff, except that the government collects no tax revenue. (The equivalent amount of revenue goes instead to those firms with the legal authority to import goods.) Because free trade is efficient, the winners from free trade should be able to compensate the losers so that everyone becomes better off. Thus policies to assist those who are harmed by trade, such as assistance and retraining for workers idled by imports, are usually preferable to trade restrictions.
The appendix to the chapter shows how to use algebra, rather than the graphical analysis presented in the chapter, to address the same international trade issues.
