Economics: Exports in an Open Economy

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We're back on location, talking some more about international trade. That's why I'm wearing my special shirt. In the last lecture, we showed how you could use the supply and demand diagram to represent an equilibrium when the world price is given. Remember we were talking about France and this product, the pomelo. Let's look back at that diagram that we drew before.
The red curve represents domestic demand and the blue curve represents domestic supply. The world price is given and the difference between domestic demand and domestic supply at that price is the volume of imports. Now, notice something; if France were a closed economy and had to make its own pomelos, the price would be up here at P*, where the curves intersect. Because the world price is below this price, the price that would occur in a closed economy, we say that France does not have a comparative advantage in the production of pomelos. That's why France imports them. Because if French farmers had to make pomelos themselves, their costs would very quickly rise above the world price; that is, the blue curve rises very quickly above P[W]. It's cheaper for France to import its pomelos rather than to make them at home.
Now we're going to talk about another case. In this second case, we'll look at another product, where France does have a comparative advantage; that is, a situation where the world price is greater than the domestic equilibrium price. The product that we'll choose to examine is wine. Let's imagine now that France is, for the sake of our story, a small country when it comes to the production of wine. That means that France can buy all of the wine that it wants and make all of the wine that it wants without influencing the world price for wine. We have to make this assumption of a small country, even though its' unrealistic. We have to make it, in order to be able to use the model that we've been using. So let's look at the picture.
In this case, the red demand curve represents the domestic demand for wine. It tells us how much wine people in France would like to consume at different prices, given their income, price of substitutes, complements and all of those other things that influence demand. The blue curve represents the domestic supply of wine. As the price rises, producers in France will make and offer for sale more and more wine as they are able to cover the increasing opportunity cost of making more and more wine. If France were a closed economy, the price of wine would be determined where the demand curve and the supply curve intersect. This would be the equilibrium price and here you'd have the equilibrium quantity. Now, let's suppose, for the sake of our story, that the world price for wine is greater than this equilibrium for a closed economy. Let's put the world price for wine way up here, maybe $8.00 a bottle. At this world price for wine, we can draw in a dashed line that touches the demand curve and the supply curve. And we'll see how the French economy would respond to this opportunity to trade at this world price. Well, notice first, at this high price for wine, French consumers want to purchase this quantity, determined by the intersection of P[W] with the demand curve. The quantity of wine demanded domestically we can write down here on the axis as Q[DD]. The quantity of wine domestically can be found by going over to the domestic supply curve. At the price of $8.00 per bottle, the domestic producers of wine want to produce this larger quantity. And we can mark it down here on the axis as Q[SD], the domestic quantity supplied. Now, notice; the quantity supplied domestically is greater than the quantity demanded domestically at this higher price. If we were in a closed economy, of course, this could not be an equilibrium. The bidding mechanism would push the price of wine downward, until we reached the intersection of the two curves. But, because we have an opportunity to trade internationally, this higher price for wine does not give us an excess supply, but rather gives us a lot of extra wine that can be exported. The difference between domestic consumption of wine and domestic production at this high price becomes France's export volume; that is, the difference between the two is the quantity of wine exported. The equilibrium in this case is not a price level. The price level is given to us from outside the model, outside the story. The equilibrium is a volume of wine exported, a difference between the quantity supplied and the quantity demanded in France at this particular world price.
International Focus
Microeconomics Background
Understanding Exports in an Open Economy Page [1 of 1]