THE LESSONS FOR TRADE POLICY

The team of Isolandian economists can now write to the new president.
Dear Madame President.
You asked us three questions about opening up trade. After much hard work, we have the answers.
Question. If the government allows Isolandians to import and export steel, what will happen to the price of steel and the quantity of steel sold in the domestic steel market?

Answer: Once trade is allowed, the Isolandian price of steel will be driven to equal the price prevailing around the world If the world price is now higher than the Isolandian price, our price will rise. The higher price will -reduce the amount of steel Isolandians consume and raise the amount of steel that Isolandians produce. Isoland will, therefore, become a steel exporter. This occurs because, in this case, Isoland has a comparative advantage in producing steel. Conversely, if the world price is now lower-than the Isolandian price, our price will fall. The lower price will raise the amount of steel that Isolandians consume and lower the amount of steel that Isolandians produce. Isoland will, therefore, become’ a steel importer. This occurs because, in this case other countries have a comparative advantage in producing steel.

Question. Who will gain from free trade in steel and who will lose, and will the gains exceed the losses?
Answer. The answer depends on whether the price rises or falls when trade is allowed. If the price rises, producers of steel gain, and consumers of steel lose. If the price falls, consumers gain and producers lose. In both cases, the gains are larger than the losses. Thus, free trade raises the total welfare of Isolandians.

Question. Should a tariff be part of the new trade policy?

Answer. A tariff moves the economy closer to the no-trade equilibrium and, like most taxes, has deadweight losses. Although a tariff improves the welfare of domestic producers and raises revenue for the government. these gains are more the in offset by the losses suffered by consumers. The best policy from the standpoint of economic efficiency. would be to allow trade without a tariff We hope you find these answers helpful as you decide on your new policy.

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