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

620 PART 4 • 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 1 cheese to 1
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.