a. Consider the following diagram:
In a closed economy, the equilibrium price and quantity are defined by the domestic demand and supply; and it happens at price, P1, and quantity, Q1.
b. When the economy becomes open to international trade eventually, the prices of the product falls, as follows:
Due to the fall in the price:
i. The domestic demand for this good (say Good A) increases.
ii. However, there is a fall in the supply of the good.
iii. This deficit or the supply gap is filled by imports.
c. There is a rise in real income due to the fall in prices of Good A. This induces the consumers to increase the demand for the other goods in the economy (say Good B).
d. The increase in the demand for Good B increases the prices of this product, as follows:
Due to the increase in the price of Good B,
i. There is an increase in the supply of the product.
ii. However, at the same time, there is a lower demand due to the high prices.
iii. This supply gap or the surplus is filled by the import of this product.
e. Therefore, we can see that as a result of the opening up of the economy to international trade, there is an increase in the quantity produced and consumed in an economy. Thus, there is an increase in the national income or the GDP.
f. Thus some of the benefits of international trade are:
i. The countries gain from the exchange and specialization. As a result of international trade, the exports occur at higher prices and imports at lower prices.
ii. Industries experience greater economies of scale.
iii. Households and firms have greater product variety.
iv. There is increased competition.
v. There is a better and more efficient resource allocation.
vi. There is a reduced monopoly of domestic firms.
vii. There is an increase in GDP due to efficient allocation, higher productivity, knowledge spillovers, and increased pace of innovation.
g. International trade also has some costs associated; they are:
i. It creates the potential for greater income inequality.
ii. There is a loss of jobs in the developed countries, especially structural unemployment, which is most difficult to fix.